THE ESTATE PLANNING MANUAL

THE ESTATE PLANNING MANUAL FOREWARD We have dedicated a substantial portion of our time, resources, and energies to Estate Planning and Estate Administration. It is our goal with this manual to help provide you with the necessary information to begin the planning process, to explain some of the options, or choices, available to you, and to provide to you the tax pictures which may result. We want to focus on the best plan for you, consistent with your personal objectives. The information contained in this manual will acquaint you with a number of concepts and terms which may be new to you. In some instances the concepts are interrelated, that is, the use of one estate planning approach may have a tax cost or a limitation which will impact some other aspect of your plan. Do not worry about these fine points; that is our job. The page margins have been made wide, so you may write questions directly in the manual. It is yours to keep. Upon completion of your plan and execution of appropriate documents, you will be provided with a bound volume, incorporating the plan information, correspondence, and documents, as signed. From time to time changes occur in the statutory, case and tax law. Sometimes your family circumstances or assets change. Please consult us if you have any concerns regarding your plan. However, in all events, your plan is to be reviewed every three years or more often. Thank you for the trust which you have placed in our firm. We, in turn, will provide you with our best counsel. Rev 8/1/01 David C. Reid, Esq. The Estate Planning Process Table of Contents 1.0 2.0 3.0 4.0 5.0 Introduction of the Planning Process Law of Intestacy/Statutory Property Distribution Probate/Distributing Property as you wish Ownership of Property Taxes 5.1 Federal Estate and Gift Tax - an overview 5.2 Federal Unified Credit 5.3 Step up in basis of assets 5.4 Unlimited marital deduction 5.5 Charitable deduction 5.6 Special situations 1. Special use valuation (Section 2032) 2. 6166 tax deferral 3. Chapter 13 (Generation Skipping Tax) 5.7 The Estate as an Income Tax Entity 5.8 New York State Estate Taxes Trusts under Will 6.1 Credit Shelter Trust 6.2 Disclaimer Trust 6.3 QTIP Trust 6.4 QDOT Trust 6.5 Charitable Trusts Trusts During Lifetime 7.1 Revocable Trusts-"Living" Trusts 7.2 QTIP Trust 7.3 Irrevocable Insurance Trusts 7.4 Charitable Trusts 7.5 Grantor Retained Income Trusts 7.6 Grantor Trusts in Personal Residence 1 5 9 12 15 15 18 20 22 27 31 32 32 33 35 39 43 43 46 48 51 52 56 56 60 62 67 69 73 6.0 7.0 Table of Contents Page Two 8.0 Pension and Profit Sharing Benefits 8.1 Spousal rights 8.2 Spouse's election to roll-over benefit 8.3 Options of Payment of IRA and pension benefits Business Succession Planning 9.1 Buy Sell 9.2 Recap of shares 9.3 Family Partnerships 75 75 76 77 79 80 84 86 89 9.0 10.0. Selecting the Executor, Trustee or Guardian 11.0 Powers of Attorney, Health Care Proxies, Living Wills and Medicaid 11.1 Power of Attorney 11.2 Health Care Proxies 11.3 Living Wills 11.4 Medicaid Attorneys Fees 12.1 Planning 12.2 For the Estate, after death Conclusion Exhibit A. Table of Descent and Distribution Exhibit B. Federal Estate Tax Rates 94 94 95 96 97 99 99 100 102 103 104 12.0 13.0 1.0 INTRODUCTION TO THE PLANNING PROCESS People sometimes fear confronting their mortality. No one likes to go to the doctor or dentist. We are reluctant to visit with our life insurance agent. There are some among us who believe that if we go to a lawyer to draw a will, something bad will happen to us. Too often, we don't do anything until we are ill, or we need cash for a buy out agreement, or we are about to take our whole family on a vacation to Hawaii. It is part of human nature and understandable. Yet, there is another approach which rationally we know is better. It is to plan for the future. There will be loss at death, but there can be a sense of order, a plan thought out with a full realization of the hopes and fears which we have for our loved ones. We can develop a plan which allows each of us to exercise our best judgment based upon the facts known to us, counseled by knowledgeable professionals and a plan which allows us to take full advantage of the state and federal laws. In the final analysis, we should plan our estates because we want to make the important choices, and not leave matters to the uncertain hope that somehow, things will work out. 1 What is Estate Planning? Estate planning is the process by which your personal and financial objectives for your family or loved ones are accomplished following death. The process usually begins by you asking questions, "What if?", "How?", "Who?", "What resources are available?", "What are the costs?” and “What are the benefits?" The answers usually are not forthcoming in a day or a week. Often, there is a good deal of discussion to finally determine the plan which is best for those who will survive you. Thus, estate planning involves: 1. 2. 3. 4. disclosure of financial and personal information, discussion and identification of objectives to be achieved, presentation of the options available to meet defined objectives, recommendations of how best to proceed understanding the costs and benefits, including taxes, 5. 6. preparation of documents to effectuate the plan selected, and follow up with the client's other personal advisors to make sure that the plan is put into effect. To begin the planning process, our firm requires that a questionnaire be completed by you. This accomplishes several things. First, we both will know that you are serious about proper estate planning. Second, it gives us a financial snapshot of you, helping us to recognize whether there are gaps in your financial picture or whether that picture is out of focus, so that we can, after further examination, suggest ways to complete a better picture. Third, it gives us some personal information about you and your family. Lastly, it gives 2 us an opportunity to focus on several planning options prior to meeting. We believe that this approach is time and cost effective. Next, we hope that you will take some time to read this manual. It presents some of the fundamental laws applicable in the development of an estate plan. The concepts and strategies described in this manual are not necessarily all applicable to each plan, but we have tried to set forth those concepts which have application to many client plans. As you go through the manual, questions will come to mind or you may want a more complete discussion of a concept. If so, make a notation in the margin of the page for future meeting reference. Finally, there are three matters of which we would like you to be aware. First, all information given to us by you is confidential and privileged.Second, when dealing with the estate plan of a husband and wife, we sometimes ask ourselves which spouse do we represent? This is especially true if there is a second marriage. If one spouse comes to our firm for an estate plan, all information will remain privileged and confidential. If both spouses come to our firm, then absent any understanding from both spouses to the contrary, we will prepare plans for you both, taking into account your marital and economic partnership. The financial and personal information of one spouse may impact the estate plan for the other spouse and therefore will be disclosed. Third, we tend to focus on strategies to reduce the taxes and transfer costs of passing property to a spouse, the next generation or a loved one. That is our obligation to you. However, you should understand that the decisions regarding the transfer of your property are yours to make. We will provide our best advice, 3 based upon our training, knowledge and experience, but you are free to accept or reject such advice. It is, after all, your estate plan. 4 2.0 LAW OF INTESTACY/ STATUTORY PROPERTY DISTRIBUTION When a person dies without having a valid Last Will and Testament, the person is said to have died intestate, and a statutory scheme of property distribution is imposed upon those assets owned in the decedent's name alone. This is sometimes referred to as the law of descent and distribution (See Exhibit A). It is a method of property distribution based upon the New York State Legislature's view of how a reasonable person would dispose of property under various scenarios, depending upon whom the decedent left as survivors. For example, if a person died without a will and left a surviving spouse and one or more children, the spouse would receive $50,000 in cash, plus one-half of the net estate. The remaining one-half of the net estate would be payable to the children equally. It would make no difference whether the children were infants or adults, nor whether this pattern of distribution met the family's particular needs. One size fits all. Also, since the distribution pattern is set by statute, it applies without regard to the tax consequences or administrative burdens which are imposed. If the decedent died owning investment real estate, title to such property would vest in the heirs at death, subject to the call of the legal representative for payment of estate obligations. However, if the real estate was to be sold because it was an inappropriate investment for infant children, a Court 5 proceeding would need to be commenced to confirm the sale, and any infant children would be represented by a guardian since such infants would be title holders prior to the sale. This causes delay, expense and can affect the sale price. If, on the other hand, the decedent left no children but was survived by parents and a spouse, the entire estate would pass to the spouse. Would it make a difference if the decedent and spouse were married only two weeks? Suppose the decedent was survived only by children ages 5, 17 and 22 and no spouse? The children, in spite of their very different needs, would receive equal shares of the estate. The five year old’s share would be managed by a guardian who would have to seek court permission for each and every expenditure of funds. The funds of the seventeen year old would be subject to a guardian's control for another year until the child reached the age of eighteen, at which point the child would be considered an adult and entitled to his or her share. The twenty-two year old would receive his or her share outright. Who will be the guardian for the children? That decision will be up to the Surrogate's Court to decide with little, if any, guidance from the decedent. Parents? A brother-in-law? An aunt or uncle who have not seen the children in the past four years? 6 In addition, the law of intestacy places an unnecessary burden in determining who will be the legal representative of the estate. Such legal representative is called an Administrator. In the first and second example, the surviving spouse would have a priority by law to be the Administrator, assuming the spouse had the capacity to serve. Suppose the surviving spouse was of advanced years and would be overwhelmed by the prospect of being the Administrator. In the first example, if the spouse could not serve, then each child would each have an equal right to serve as Administrator, assuming that each such child was eighteen years of age or older. Who is going to serve? Will such child be paid a commission as allowed by statute for such service? Will the other children consent? In all probability, each child would seek out his or her own legal counsel shortly after the funeral and the costs will unnecessarily increase. Assuming that a petition for the appointment of an Administrator is pending before the Surrogate's Court, and the Court is prepared to order the appointment of one of the adult children, there will be the requirement that the Administrator post a bond prior to the Judge signing the decree. In the third example, the 22 year old child would have an immediate priority to serve as Administrator because his siblings, as infants, would not have the capacity to serve. The Court would most certainly require a bond, which would be an additional estate expense. 7 In summary, the law of intestacy with its "One size fits all" approach is a poor method of trying to bring order to the financial affairs of a person who, during lifetime, should have had more regard for the future of his family and loved ones. The application of the law of intestacy means additional legal expense, administrative costs and in some instances, additional estate taxes. Above all, its application causes unnecessary stress and may not provide the needed resources to the surviving family members. 8 3.0 PROBATE/DISTRIBUTING PROPERTY AS YOU WISH With few limitations, the laws of New York State, as well as other jurisdictions, permit a person to pass or transfer property to those persons whom such person chooses by a written instrument called a Will. In order to have a valid Will, you must be eighteen years of age or older, be mentally competent, know the nature and extent of your assets and know the natural objects of your bounty, ie, your heirs. You must not be acting under duress nor be the subject of undue influence of others who would not allow you to freely express your wishes by such a written instrument. A Will must be in writing and subscribed at the end by the testator (you) and attested to by at least two witnesses. A Will may be as simple as a single sentence or many pages, depending upon the requirements of the client in the transfer of his or her property. A Will can transfer real estate, stocks and bonds or virtually any property interests which the testator owns in his or her name alone. A Will can be used to create trusts which continue after death to carry out specific purposes of the testator and provide estate tax savings to the family. A trust is created by the transfer of ownership of property to a trustee whose job is to earn income and cause the trust property to grow in value over time for the benefit of designated beneficiaries. For example, if a 9 surviving spouse did not have the ability or desire to manage investments, or if the testator desired to protect funds from creditors of the surviving spouse, a trust could be created under the testator's Will to accomplish such goals during the surviving spouse's lifetime, with payment over to the testator's children when such spouse died in the future. Since the trust is created by Will, it is called a "testamentary trust." In addition, a Will permits you to nominate the person or persons who will serve as guardian of infant children. Inasmuch as the Will is considered to be a document of serious thought and judgment, the Court will give great weight to the testator's nomination of the guardian. The testator may nominate the person who will be the legal representative of the estate. This is probably one of the most important decisions which the testator makes. The legal representative is charged with the preservation of the estate assets which may represent a lifetime of work by the testator. In New York State, the Court which has general jurisdiction over the decedent's affairs is called the Surrogate Court. It is an elected County Court position. In smaller counties, the Surrogate judge may also serve as a County Court judge, as well as Family Court judge. In more populated counties, there may be more than one judge responsible for Surrogate's Court work. 10 Your Will, as written, is not deemed to be your Will until the Surrogate judge declares by Court Order that it is, in fact, your Last Will and Testament. The process to prove your Will is called Probate. You will recall that New York State has created a will for you through the law of intestacy. In other words, but for the existence of your written Will before the Court, certain of your heirs would receive your property under the law of intestacy. Your Will changes this statutory pattern of distribution and, therefore, it can to cut off certain heirs, called distributees, from having any interest in your property. Your Will is said to divest your distributees of their statutory intestate property rights. Thus, Probate is the process by which the Court states that the Will is valid in all respects, permitting property to pass as the Will directs. Some clients worry that a disgruntled relative will "contest" the Will. The possibility of a Will contest is greatly exaggerated. In most instances, a will contest arises if the testator is elderly and ill. The issues raised are (1) lack of testamentary capacity and (2) undue influence, or both. In the vast majority of cases, the possibility of a Will contest is not worth losing a minute's sleep over. If, nevertheless, you are worried about "those relatives" coming out of the woodwork, there are strategies to deal with the matter. Indeed, that is one reason why a client should have an estate plan. See Revocable Trust Manual and Article at Website: dcreid.com 11 4.0 OWNERSHIP OF PROPERTY It is critically important to the estate planning process that you disclose in full the nature and extent of your assets. This involves knowing the titled ownership of all assets. It is through the disclosure of assets and liabilities that issues are raised involving the management of particular assets and the lessening of liabilities. Such disclosure helps us develop an estate tax picture. What are the problem assets? What can be done to change the tax picture consistent with what you wish to accomplish? What are the tax costs of your assets? What lifetime actions can be taken to deal with low tax cost assets? How can the assets be preserved for the family? There are four basic types of asset ownership, plus some special situations. The first type of ownership is outright title to the property. In describing real estate, this type of ownership is called "fee simple absolute" or "fee simple". The client is the sole title owner of the stock, bank account, real estate or motor vehicle. There may be an encumbrance or loan against the property or it may be pledged, but the client is the sole owner of the asset. Recall that your Will is only effective over property which is in your name alone. 12 The second type of ownership is when two or more persons are coowners of property and it is owned as "tenants-in-common". In describing real estate, this means that each owner has an undivided interest in the property which each owner can convey during lifetime or it can pass by that owner's Will. Upon death, the property interest does not pass to the other co-owner. The property becomes part of the deceased owner's estate. Generally, unless there is further language describing the title to the asset, co-owners will be owners as tenants-in-common. As a practice note, the issue of owning property as tenants-in-common is raised with bank accounts that are owned together by family members who assume the account will pass to the survivor based upon the legend in the passbook or description on the certificate of deposit. The actual registration card should be examined. The third type of ownership of an asset is as "joint tenants with right of survivorship". At death, title will pass to the survivor of the co-owner(s). Title is said to pass by operation of law to the survivor. This type of asset Assets registration is sometimes referred to as "the poor man's Will". registered in this fashion are not subject to the provisions of a Will. Such assets by-pass the Will and vest directly in the surviving tenant. An exception to this rule can occur with regard to bank accounts which are set up to be "accounts of convenience" for the person whose money makes up the account. If you intend to have an account of convenience and not vest 13 title in the survivor, the bank account registration card must reflect this, otherwise you will place your legal representative in a difficult position when attempting to get the bank account back into the estate. In all events, you should be sure that whenever you are a co-owner of an asset, you have proof of your contribution to the asset. This will be important information for a legal representative in the preparation of applicable state and federal estate tax returns. Finally, let it be re-emphasized that the full ownership description, including "with right of survivorship" must be indicated on title if you intend ownership to pass at your death. If not so specified, then the asset is deemed to be owned as tenants-in-common. The fourth type of property ownership is similar to joint tenancy with right of survivorship, however, it is created by married couples. It is called "tenants by the entireties" and only applies to married persons. Upon the death of one co-owner, the property vests in the survivor by operation of law. There are special rules regarding the taxability of this type of asset for estate tax purposes. There are assets which can give rise to special treatment such as options, life insurance and annuities. There may be ownership interests in trusts, established in prior years, of which a client is deemed to be the owner for estate tax purposes. The client may, in fact, have no title interest in such trust. The client may have a power to appoint the trust property or have a 14 power to withdraw funds from such trust so that such client is deemed the owner of the trust for estate tax purposes. These kind of assets require careful attention in the planning process. 15 5.0 TAXES In the orderly transfer of property, part of the potential cost to the family is the reduction of assets due to the application of state and federal death taxes. The taxes which may be generated are said to be tax inclusive, that is, the tax is calculated on the value of the estate from which the tax is paid. Thus, if the value of the estate is 100 and the tax is 20, the tax is not based upon a value of 80, but rather on the 100, which includes the tax itself. The net transfer is 80. One of our primary efforts is to advise you how to minimize the exposure of assets to estate taxes. And yet, while taxes may be a major consideration, in some cases, taxes are subordinate to a client’s other objectives. 5.1 Federal Estate and Gift Tax - an Overview. Prior to 1977, there was a difference in the gift and estate tax rates, the former being 75% of the latter. There was a tax incentive to make gifts because of the rate differential and the fact that the gift tax which was paid was removed from the net worth of the client. Thus, the value of the gift, plus the gift tax paid decreased the size of the estate. In 1977, the federal gift and 16 estate tax systems were unified and the rates were made the same. At death, any lifetime taxable transfers must be added to the value of the taxable estate and the ultimate estate tax paid on the resulting figure. It is this unified gift and estate tax system which is applicable to transfers today. One important opportunity for gift tax purposes remains the availability of the annual gift tax exclusion, currently amounting to $10,000 per donee on a yearly basis. Thus, you can make a gift to anyone of $10,000 each and not have to file a gift tax return, nor will the gift be a taxable transfer for estate tax purposes. The $10,000 gift limitation includes all gifts made during the tax year, even personal gifts such as birthday or holiday gifts. Thus, to keep flexibility, annual gifts are often made slightly below the $10,000 limitation. An example of the power of annual gifting is as follows: Suppose the client has 4 children, each of whom is married and that each such child has 2 children of their own. This would mean that for gift tax purposes, the potential family recipients, including children's spouses, could number 16, or the property equivalent of $160,000. If the client is married, his or her spouse can elect to split the gifts and use such spouse's own annual gift tax exclusions as well. The result would be a potential transfer of $320,000. If the first series of gifts were made in December and the second series were made in January of the next tax year, the total assets removed from the client's estate within the span of 30 days or less could be as much as $640,000. These are 17 assets from the top estate tax rates which would otherwise apply to the client's estate. In addition to the annual gift tax exclusion, there is provision in the gift tax law which allows for the payment directly to the provider of tuition for education or of medical expenses of the donee and such payments will not count against the annual gift tax exclusion amount. As a result of the 1981 Tax Act, transfers between husband and wife during lifetime do not result in taxable transfers for gift tax purposes. Thus, today, with the exception of transfers to a non-citizen spouse, it is possible to freely transfer assets between spouses. This is an important estate planning tool since assets of the marital partners can be re-arranged to effectuate the most efficient tax plan. The tax rates for the federal gift and estate tax are graduated. The larger the taxable transfer, the more the tax will be. The rates begin at 18% and rise to a maximum of 55%, the latter for taxable transfers of $3 million or more. (See Exhibit B). But against this tax there is some relief, a tax credit. There are three important tax concepts in the federal estate and gift tax law with which the client should become familiar and which are discussed below: these are (1) the federal unified credit; (2) the step up in basis (tax cost) of assets at death; and (3) the unlimited marital deduction. 18 5.2. The Federal Unified Credit The federal unified credit was introduced in 1977, but did not become meaningful until it was expanded as part of the 1981 Tax Act. In 2000, the federal unified credit amounts to $220,050. This is a credit on a dollar for dollar basis against the gift and estate tax. It is the property equivalent of $675,000. Each person is entitled to this tax credit and because of the unification of the federal gift and estate tax law, the unified credit will take into account lifetime taxable transfers. On occasion, such as in a closely-held business setting, the client will purposely use the full unified credit for lifetime transfers of business stock so that the future appreciation of the company stock will belong in the donee and not to the donor. Each individual taxpayer has a federal unified credit, which, absent its use during lifetime, is available at death to be credited against any federal estate tax. Most estates are planned with the use of the remaining federal unified credit in mind. For example, between a husband and wife, there is a potential for the transfer of $1.35 million without the imposition of a federal or New York state estate tax at death. This means that the unified credit of both the husband and wife would be fully utilized. See scheduled increases, below and Exhibit B 19 The unified credit is scheduled to increase over the next 7 years until repeal in 2010 as follows: Year 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Unified Credit 220,500 345,800 345,800 555,800 555,800 780,800 780,800 780,800 1,525,800 Repeal Property Equivalent 675,000 1,000,000 1,000,000 1,500,000 1,500,000 2,000,000 2,000,000 2,000,000 3,500,000 Repeal ( If not reauthorized by Congress, the rates and credits of 2002 will become applicable again. ) In the moderate sized estate, the full use of the remaining unified credit may not be a concern, especially when the survivor has the annual gift tax exclusion available to reduce the survivor's estate. The estate planning for a family with assets of $800,00 will necessarily be different from the family which has assets in the range of $1,000,000 and more. In both instances, however, estate planning is important. Over time, assets will increase in value. Moreover, once the federal estate tax kicks in, the rate effectively begins at 37%. The tax rates increase as the value of the taxable estate increases. Often, the estate plan for a larger estate involves the establishment of a trust under the husband's Will. The trust is used to hold the unified credit amount. The trust is usually for the benefit of the surviving spouse and there 20 is provision for the invasion of principal, but the trust is designed so that the trust and its assets are not included in the taxable estate of the surviving spouse upon her later death. The surviving spouse will have the economic benefit of the trust assets, but upon her death, the trust principal will pass to the children, or to whomever the client wishes, without the trust principal being subject to estate tax exposure. 5.3 Step Up in the Basis of Assets. It is important to know the tax cost of assets in planning since this information can have a direct effect upon the income taxes which a client pays during a lifetime. Investments over the years may grow in market value and/or, if real estate, such real estate may have been fully depreciated or have negative basis. Indeed, investors become reluctant to divest themselves of low tax cost assets because of the capital gains tax liability which can be incurred. Often, these low tax cost, or low basis, assets are held until death. The present tax code allows for a full "step up" in basis for such low tax cost assets to their fair market value at death. Similarly, in dealing at death with an asset for which a premium was paid at purchase during lifetime and which has a high tax cost, the fair market value of the asset at death will become the new tax cost of the asset. It is the fair market value of the asset at death which will determine the assets' new tax cost. The thinking for allowing a new tax cost 21 for assets at death is that death is usually an involuntary event. The records are often unavailable to an executor (we all don't keep perfect tax records), and if the same assets were subject to both a capital gains tax and an estate tax, the result to the taxpayer's estate would be a very large tax (55% plus 20%), plus state death taxes. Congress tried to impose such an absurd provision in 1976 with "carryover" basis for estates. The law was complex, required vast record keeping and was unworkable. It was repealed. Of course just because a law is poor, doesn’t mean that Congress won’t use it again Congress has a poor memory.One of the provisions of the new law when the estate tax is repealed, is that the assets not passing to a spouse will get a step up in basis on only $1.3 million. Aseets passing to spouse will get a step up in basis of up to $3 million. The result may be substantial capital gain as heirs begin to diversify the decedent’s portfolio. The importance of obtaining a new tax cost (new basis) in assets at death prior to 2010 cannot be over emphasized. With a step-up in basis, the estate of the taxpayer is free to diversify out of low tax cost assets which were held by the decedent. Thus, the estate can liquidate a large block of stock or sell a parcel of investment real estate and not be concerned with the tax cost which the asset had during lifetime, or substantial capital gain tax exposure. There is a special rule applicable to a husband and wife if they own an asset as joint tenants with right of survivorship or as tenants by the entireties. 22 As a general rule, each marital partner is deemed to own a one-half interest in such property for estate tax purposes. Accordingly, there is only a one-half step-up in basis upon the first joint tenant's death. If a husband and wife hold title to a large block of low tax cost stock as joint tenants with right of survivorship, upon the husband's death, only one-half of the asset will receive a new tax cost. The surviving spouse retains her original tax cost as to her one-half interest. Understandably then, the titled ownership of property is important and the tax cost of an asset is also important. As part of the planning process, it may be advisable to rearrange the ownership of assets not only to make sure that each spouse's unified credit can be used, but also to cause assets to receive a full step-up in basis at death. 5.4 Unlimited Marital Deduction. When a taxpayer calculates his or her income tax each year and itemizes deductions, those deductions are subtracted from adjusted gross income. This lowers the amount of income subject to taxation. Similarly, there are certain deductions for estate tax purposes which are available in arriving at the taxable estate. One such deduction is the marital deduction which is allowed for property passing to a surviving spouse. Historically, the marital deduction was placed in the estate tax law because of the differing tax results which occurred for taxpayers who lived in community property states 23 compared to those taxpayers who lived in common law states. In a community property state, the assets earned over the course of the marriage were deemed to have been owned one-half by each spouse and therefore, upon the death of one spouse, only one-half of the value of the asset was included in the estate of the decedent. In a common law state, the spouse who earned the asset and in whose name the asset was held was the owner of the asset and its entire value was included in the owner's estate. Thus, common law states, such as New York or Florida, imposed a greater federal estate tax burden on the decedent's estate, when compared to that in a community property state. The marital deduction was made part of the federal estate tax law and amounted to one half of the adjusted gross estate which was the value of the estate after subtracting funeral and administration expenses and debts. The 1976 Tax Act changed the marital deduction by allowing the marital deduction to be the larger of $250,000 or one half of the adjusted gross estate. This modification, taken together with a small unified credit, caused many small estates to be exempt from federal estate taxation. The significant change in the marital deduction came with the 1981 Tax Act. This was the Tax Act which enlarged the federal unified credit so that today it is the property equivalent of $675,000. The marital deduction was modified to make it unlimited, with the exception of transfers to a non-citizen spouse. Thus, for transfers from one spouse to another, either during lifetime 24 or at death, property passing from one spouse to the other spouse is generally exempt from tax. The size of the estate or transfer is irrelevant. The allowance of the unlimited marital deduction is based on the theory that the husband and wife are a single economic unit, like a partnership, within which property is freely transferable. Neither gift nor estate tax is to be applied to such transfers, as a general rule. As mentioned. there is an exception for transfers to a non-citizen spouse. Nevertheless, the free transferability of assets between spouses is an important estate planning tool, since it allows the transfer of assets from the spouse who may have a large amount of property to a spouse who may have a small amount of property thereby permitting each spouse to take advantage of the federal unified credit in each of their estates. For example, if one spouse is in very poor health, it may be advisable to transfer low tax cost assets to such spouse so that in the event of death, a year or more into the future, those assets will receive a new tax cost at the death of such spouse and will come back to the surviving spouse (donor) under provision of the unlimited marital deduction. This is a somewhat macabre tax option, but it is allowable under the tax law. The 1981 Tax Act also introduced the qualified terminable interest property trust (QTIP for short). Traditionally, a testator could create a trust for the surviving spouse, but in order for the trust to qualify for the marital deduction, the trust either had to be paid to the surviving spouse's estate at her 25 death, or the surviving spouse had to be given a general power of appointment over the trust, thereby allowing her to have the power to leave the trust assets to any person upon her death. Absent this arrangement, any property left in trust for a surviving spouse which another person could enjoy after the spouse's death would not qualify for the marital deduction. For example, if the decedent provided for an annuity for the surviving spouse with payment over to their children of any residual benefit, the annuity would not qualify for the marital deduction. Or, if the testator created a trust whose income was paid to the surviving spouse for her lifetime and with the principal upon the spouse's death payable to the children, such a trust would not qualify for the marital deduction. In both instances, the surviving spouse was said to have a "terminable interest" in the property. With the introduction of the QTIP in the 1981 Tax Act, it became possible for both such prior property arrangements to qualify for the marital deduction. The QTIP planning device is especially appropriate for second marriages where one spouse wants to provide for the survivor and upon such surviving spouse's death, have the trust property paid over to the first spouse's children. The QTIP trust is also used to limit creditor's access to property which is held for the benefit of the surviving spouse. Asset protection is one of the purposes for trusts in general. By creating a trust to hold marital deduction assets, these principal assets are not 26 in the surviving spouse's name and are not subject to attack by her creditors. This can be important in preserving assets from the high cost of long term medical care. The QTIP trust requires that all trust income be paid to the spouse for her remaining life and no other person can have an interest in the trust as long as the surviving spouse is alive. The drawback is that the value of the trust is fully included in the estate of the surviving spouse for estate tax purposes. The allowance of the unlimited marital deduction permits the entire family wealth to remain intact during the surviving spouse's lifetime. Such wealth is not diminished by federal estate taxes at the first spouse's death. But recall that the estate taxes are graduated, which means that there is the potential of the estate taxes being higher in the surviving spouse's estate at her death, (unless the survivor takes steps to reduce her estate to a level which will be sheltered by her federal unified credit). Nevertheless, as a general rule, if you can avoid the early payment of taxes at the first spouse's death and control family wealth for further planning, that is the most desirable route to take. Remember, any property which passes to the surviving spouse will be eligible for the marital deduction. This is true of joint bank accounts, stocks, real estate, insurance, pension benefits and the like. But recall that when assets are in joint name with a surviving spouse, the asset at the first spouse's 27 death receives a new tax cost for only one-half of the asset value and the surviving spouse retains her original tax cost as to the other one-half. The use of a disclaimer after death may allow a surviving spouse to receive a full step-up in basis on joint assets. A surviving spouse's disclaimer of an individual jointly held asset will cause the asset to become owned in full by the deceased owner. The asset is not viewed as being owned by the survivor, and would pass as part of the deceased spouse's property under his/her will. For example, if the will of the first spouse leaves the estate to the surviving spouse, and if the first spouse supplied the consideration for the assets, it is possible for the surviving spouse to disclaim the jointly held asset so that the asset will become fully included in the estate of the first spouse. Due to the marital deduction provision in the deceased first spouse's Will, the disclaimed asset will pass under the Will to the surviving spouse, thereby allowing the assets to receive a full step-up in basis. However, there is a possible limitation on real property held as tenants by the entirety. New York law allows a disclaimer of property held as tenants by the entirety, but IRS allows a disclaimer of such real property only where severance of title can be accomplished by the act of a single joint tenant during the lifetimes of both tenants. In New York, one married spouse alone may not sever title to property held as tenants by the entirety. Nevertheless, the use of a disclaimer in certain marital deduction settings is an option to receive a full step-up in the 28 tax cost of jointly held assets. Certain case law may be helpful if the real property was acquired prior to 1981. It may be advisable to retitled real estate not as tenants by the entireties but as simple joint tenants with right of survivorship to allow for a disclaimer. 5.5 Charitable Deduction. While there is a percentage limitation on a person's income tax return for property given to charity, no such limitation exists for estate or gift tax purposes. The federal estate tax charitable deduction like the marital deduction is unlimited, although there are constraints of state law if the testator leaves a surviving spouse and attempts to disinherit her (See section VIII, Spousal Rights). The use of the charitable deduction is not advantageous where the plan utilizes the unlimited marital deduction, or when the unified credit entirely absorbs the potential federal tax of the estate. For example, if a cash legacy of $10,000 is given by Will to a charity and the remaining estate is given to the surviving spouse, there is no estate tax advantage because the deduction for the charitable legacy is meaningless in a nontaxable setting. Therefore, the decedent may wish to trust his spouse to make the charitable gift from assets passing to her after the decedent's death so that she will receive an income tax deduction. The appropriate provision in the testator's will would state that the legacy is to be paid to the charity if his spouse did not 29 survive him. If there is no marital deduction, the charitable gift would have an impact in the reduction of the testator's estate tax where the taxable estate exceeded the unified credit. Charitable gifts can have a significant impact in reducing the estate taxation of a single taxpayer's estate at death. Aside from outright charitable legacies, charitable trusts can provide a continuing source of income for the lifetime of a beneficiary, such as a child, brother or sister or other person. Such a charitable trust, called a split interest trust, can provide an annual fixed dollar amount or a stated percentage of the annual fair market value of the trust as income to the designated beneficiary. The former is called a charitable remainder annuity trust and the latter is called a charitable remainder unitrust. The stated calculated amount (income) is paid to the beneficiary, usually for life, after which the remaining trust assets are paid over to the charity. In valuing such trusts for estate tax purposes, the remainder interest which will be paid over to the charity in the future is valued as a percentage of the amount used originally to fund the trust. This value is subject to an adjustment for a floating discount factor called the 7520 rate. For example, if a $200,000 charitable remainder annuity trust is established for a beneficiary who is 65 years old, the amount of the charitable deduction for the remainder interest which will eventually pass to charity based upon a 6% return, as adjusted, or $12,000/year, is 39% or $78,244. This is the amount that can be deducted on the estate tax return in arriving at the taxable estate. 30 For an income beneficiary 75 years of age, the percentage is 53% and the amount of the deduction is $106,216. In addition, the law provides for a charitable lead trust where the calculated annual amount becomes payable to the charity for a stated period of years (not in excess of 20 years) and the remainder interest passes to individuals upon the expiration of the term. The deduction allowed is based upon the income stream which will go to the charity. It is possible to avoid federal estate tax on such a trust if the percentage of annual calculated amount allocated is large enough and the term long enough. Charitable trusts established during lifetime can present income tax savings and investment opportunities. The lifetime transfer of appreciated securities to a charitable remainder trust allows the trust to diversify the assets received without the recognition of capital gains tax on the sale by the trust of low tax cost assets. Also, the rate of calculated annual payments to be paid to the beneficiary (who often is the donor or Grantor of the trust) may, and often does, exceed the income received on the assets originally placed in the trust. In addition, the donor/Grantor will receive a charitable deduction for the remainder interest for income tax purposes which, if not used in full in a particular tax year, can be used in succeeding tax years (up to five years). The drawback to any charitable remainder trust is that the principal cannot be invaded for the income beneficiary. Under prior tax law, charitable 31 trusts were sometimes established for the benefit of a surviving spouse under the testator's Will. The income interest would be eligible for the marital deduction and the remainder interest eligible for the charitable deduction. With the 1981 Tax Act and the introduction of the QTIP trust, the entire QTIP trust is eligible for the marital deduction. The QTIP trust is not limited in the amount of income or principal which may be used for the surviving spouse. There need not be an annuity or unitrust amount and if principal is needed, provisions can be made for invasion of the trust for the surviving spouse's benefit. If a charity is the remainder beneficiary of the QTIP trust after the spouse's death, her estate will be entitled to a full charitable deduction, since such surviving spouse, for estate tax purposes, will be deemed to be the transferor to the charity and under the unlimited charitable deduction, her estate will be able to deduct in full the value of the trust at her death. 5.6 Special Situations. The Tax Code provides both opportunities and pitfalls. As part of the estate plan, we try to position the assets of the taxpayer to take advantage of the tax law, not only to minimize the exposure of the estate to tax, but to do so in a manner which will maximize the opportunities for estate tax deferral. For example, under Code section 303, if the estate is the owner of one or more corporate businesses, or has a partial interest in the same, it is possible 32 to draw money or property out of the business to pay at least a portion of the estate tax and the funeral and administration expenses. The withdrawal of cash from the corporate business will not result in dividend treatment of the distribution. The reason for this provision in the tax code is that cash is often locked up inside a business which the decedent owned. The estate itself may have little cash with which to pay the estate tax. In order to qualify for this favorable tax provision, the business interest, either singly or in the aggregate, must comprise more than 35% of the adjusted gross estate. As part of the planning process, the business client is encouraged to divest himself of those assets which would cause his estate not to qualify for the 303 redemption. Life insurance owned by the client may be transferred to another person, perhaps to the beneficiary or to a trust, to cause the business interest to become a larger portion of the client's remaining estate. The policy of life insurance will be owned by a different entity such as a trust which, upon the client's death, will have cash from the policy proceeds. Such a trust will not be part of the client's estate for estate tax purposes, and the estate will be able to use Section 303 of the tax code to unlock some of the cash which is inside the corporate business. Some other applicable code sections include: 1. Section 2032. This provision of the estate tax law primarily focuses on the family farm by permitting its value to be limited to its actual use as a farming operation and not having it taxed at 33 its highest and best use. The farm land, assuming that it will continue to be farmed, will be valued at a rental value which is far below the fair market value of the land. This can lead to a discount in value of at least 50% in the land value. Sometimes even greater discounts result. As might be expected, there are qualifications. The land must pass to a qualified heir who will actively continue the farming operation for a 10 year period and a major portion of the farm land cannot be sold during the 10 year period following death. Should the restrictions be violated, the tax will be payable on the full value of the farm land. 2. Section 6166. This provision of the tax law permits a deferral of the estate tax which would otherwise be due and payable within 9 months of date of death. Under this section of the Code, if the business interests in the aggregate amount to more than 35% of the adjusted gross estate (not the gross estate), the estate may pay the estate tax with respect to such business interests in installments over a period of 15 years. The first five years require only the payment of interest at 2% on the first million of value and 45% of federal rate for under payment of tax with the actual tax payments spread over the latter 10 years. Remember, however, this is only a deferral of the tax payment. The tax must 34 be paid and the interest must be paid. It is better to minimize the tax in the first instance. 3. Chapter 13. (Generation Skipping Tax) This provision of the Tax Code is both an opportunity and nightmare. It is applicable for lifetime transfers, as well as transfers at death. The origin of this tax was the decision by the Congress that it was not "fair" to allow property to pass to successive generations without the imposition of an estate tax, specifically when property passed from the first generation through the second generation to the third generation by means of a trust or other device. Thus, the law today states that if property passes outright or in trust to a generation which is two below that of the testator (or donor/Grantor), a tax is imposed on the property transferred. The tax is at the maximum estate and gift tax rate of 55%! It is possible in a trust setting for this tax to apply to both principal or income distributions. It can result in a significant tax burden. In most planning instances, however, the tax will not apply because property will pass upon the death of husband and wife to their children or nieces and nephews outright. If there is a trust for a child, there is some risk of the tax applying, but there is an exemption under the law amounting to slighty more 35 than $1 million for each transferor. Also, the annual gift tax exclusion of $10,000 per person/per year is available for gifts during lifetime. Such gifts are exempt from the tax. To the extent that lifetime transfers made to the third generation exceed the annual gift tax exclusion, the excess may be absorbed, if so designated, by a portion of the $1 million exemption. For some families, the use of the generation skipping tax exemption is an important planning option, especially if there is a desire to provide funds for the education of grandchildren, or where parents do not want property to pass to a child's spouse, or where the child or children have little experience or interest in the management of assets. Parents sometimes wish to establish a "safety-net trust" for the benefit of children and grandchildren to insure that not only their children, but also their grandchildren will have available significant economic resources for the uncertain future. In such a case, all or part of the exemption is used by placing property in a trust for a child's lifetime with a provision to sprinkle the income to the child or the child's descendants, and the child is given a nontaxable limited power of appointment to rearrange the trust by the child's Will. The balance of the parent's estate may be left outright to the child or 36 children with provision for a grandchild trust if any child predeceases. The planning to deal with the generation skipping tax is complex. 5.7 The Estate as an Income Tax Entity. It is probably not comforting to learn that after death, the IRS continues to have an interest in the assets which the estate owns and the income earned on those assets, as well as, other income which may be due the estate, but which is unpaid at death. At death, a person ceases as a taxpayer, but from the date of death, that person's estate becomes a new income tax entity with its own new taxpayer identification number. The planner is concerned with two classes of income. The first type of income is called Income in Respect of a Decedent (IRD). This is income which is due the taxpayer at death or income to which the taxpayer has a right, but is not received prior to death. It is treated as income for income tax purposes to the estate, but for fiduciary accounting purposes, it is treated as principal. This kind of income can badly distort the taxpayer's lifetime income tax plan. For example, if the decedent belonged to a partnership and there was no partnership agreement which terminated the decedent's interest in the partnership at death, then all of the income reported on the partnership's K-1 tax form would list the estate as the recipient if death occurred before the end of the partnership tax year. The 37 decedent during his own tax year may have created numerous deductions which would be reflected on his final 1040. Due to death, the partnership income would not be reported on the decedent's final 1040. Instead, his estate, as his successor in interest, would report the income. The estate, as a new tax entity, would not have the deceased taxpayer's deductions to offset the large reported income from the partnership. The result would be that the estate would have a large income tax, and the decedent's deductions would be wasted. Federal law modified this result by allowing a close of the partnership tax year as of date of death. Other examples of IRD include commissions or salary owed, rent or interest, bonus, deferred compensation and installment sales. Unless IRD is dealt with at the planning stage, these kind of payments, if significant, can lead to an undesired tax result. It is better by Will to specifically give these income assets to a surviving spouse who will be filing a final joint income return so that the deductions on that final income tax return can be used to offset the income specifically given to the surviving spouse. For a single taxpayer, it may be beneficial to specifically designate in the Will a charity as the designated beneficiary of IRA proceeds. The payment to charity would be eligible for the unlimited charitable deduction on the federal estate tax return and, with the charity as the designated beneficiary, the income proceeds of the IRA would never come to the estate and would not be reported 38 as income by the estate. A specific gift of Series E bonds can have similar treatment. Income in respect of a decedent, IRD, is treated as an asset on the federal estate return and is subject to both estate tax and with income tax. Congress, reflecting on the graduated income rates and the graduated estate tax rates decided that the net effect of this two tiered taxation on an income (IRD) asset was not as "fair" as it could be. Therefore, Congress provided that the federal estate tax which was paid as a result of including IRD in the gross estate could be claimed as a deduction against that income asset when it was taxed as income to the recipient. The estate tax attributable to the IRD is not a tax credit, but merely a deduction. See Code 691(c). The second class of income is regular accounting income which comes into the estate as income and retains its character as income. Examination of this income is important, since there may be significant amounts of income received by the estate within the first six months after death. The questions presented include whether and to what extent this accounting income should be distributed to beneficiaries? What are the income tax brackets of the beneficiaries? In what income tax year should the beneficiaries receive the income? Is there tax exempt income coming into the estate? The process of dealing with this income is called "post mortem income tax planning" and involves a number of concepts. First, the estate may choose its own fiscal 39 income tax year. Most taxpayers and trusts are limited to a calendar income tax year. An estate may select, for its first income tax year, any period ending in any of the first 11 months from the date of death. Thus, the tax year may be one month, six months, eight months, etc. Sometimes, the estate selects a tax year which will cause the estate's income to be included in a beneficiary's income for the following calendar tax year so that the income tax liability can be deferred on the income received today. This will permit the beneficiary to have time to plan his or her income tax strategy for the upcoming year. If the decedent had a revocable “living” trust, the Executor may elect to treat the trust income as part of the estate’s income under IRC 645. Consideration will be given to the use of administration expenses, such as commissions, attorney’s fees, costs of transfer, appraisals and the like, as part of the post mortem income tax plan. Ordinarily, these expenses are used as deductions on the estate tax return, reducing the gross estate to arrive at the taxable estate for estate tax purposes. However, if, due to the use of the marital deduction or the federal unified credit, the estate will not have to pay a federal estate tax, then the executor may elect to take such administration expenses against the estate's income. These expenses are paid from principal, but may be used as deductions, when paid, against estate income. Moreover, if this election is made in the final income tax year of the estate and such expenses exceed estate income, the excess expenses can be passed onto the 40 beneficiary to be taken as a miscellaneous deduction on the beneficiary's personal income tax return. Consideration may be given to the possibility of a beneficiary disclaiming a portion of the estate, so that a portion of the estate can pass to the beneficiary's children, thereby creating additional recipients of income who may be in lower income tax brackets. From a planning point of view, the proper treatment of estate income can be a tax savings opportunity. 5.8 New York Estate Taxes. It was not until 1983 that the State of New York unified its gift and estate tax systems and in October of that year, New York implemented provision for the unlimited marital deduction. Until February 1, 2000, New York had not adopted the exclusion from tax of an amount similar to the federal unified credit. States such as Florida, Massachusetts, New Jersey and others have adopted a provision which incorporates the federal state death tax credit, as the state estate tax. The federal state death tax credit comes after the application of the federal unified credit and it is available against the federal estate tax. If the state death tax credit is not claimed, the federal tax is not reduced. It is somewhat like deducting state income taxes on your federal income tax return. Until 2/1/2000 New York had a higher state estate tax than 41 the federal state death tax credit. The interplay of New York’s new estate and the Federal Estate is seen on Exhibit B. New York's estate tax until 2/1/2000 started at 2% and was graduated to 21%. Effective January 1, 2000 the New York gift tax has been repealed. This meant that the federal law was incorporated into the New York estate tax law. The problem presented by the 2001 federal Tax Act is that the state death tax credit is to be phased out over the next 4 years. The Feds in 2002 want the tax revenue which previously (2001) was allowed as the state death credit and went to the states. The estimated impact to Florida is that the federal government will receive the $700 million dollars of annual revenue which went to Florida due to the state death tax credit. This phase out of the state death tax credit shows a shift by the Feds to retain revenue at the expense of the states. Florida has no official estate tax and relied upon the state death tax credit. Florida has state constitutional constraints on imposing new taxes and it will difficult, if not impossible, for it enact its own new estate tax. Florida’s loss is IRS’s gain. From a tax collection viewpoint, it is unlikely at the federal level for the immediate few years that the gross revenues from the estate tax reform will decline in any meaningful fashion. After the four year phase out of the state death tax credit, there will be a deduction by the estate for the state death taxes paid. Will there be a taxable estate amount for federal purposes but 42 a different figure (without regard to the deduction) for state death tax purposes? Are we going to get into an inter-related calculation wherein we do not know the amount of the state death taxes because we don’t know the amount of the state death taxes which are deductible? Will the same be true at the federal level since the state death taxes which are deductible cannot be known until we know the amount of the taxable estate which depends upon the state death taxes. Two inter-related calculations? What a nightmare! New York’s situation is more complicated because the New York estate tax tracks the federal 1997 law and the use of the state death tax credit schedule based upon that law. There is no automatic incorporation of the new 2001 federal estate law into New York State estate tax law. Since the maximum exemption under the 1997 federal tax law amounts to $1 million for New York purposes, there will not be a wholesale revenue shift in favor of the IRS, but the result will be that New York State in the later years could impose an estate tax at the 11.2% bracket and the estate at the federal level would only get a deduction for the New York estate (not the more valuable credit). This will mean that the tax base for federal estate tax purposes will be larger than before reform. Between the federal reduced tax rate and the New York tax rate, even if deductible, the amount of total tax bite in a large estate could still be at or about 50%. Tax reform sounds good, but it ain’t easy. . 43 The greatest taxpayer problem in recent years raised by New York State has been a question of domicile for income and estate tax purposes. These inquiries by the state can be very troublesome if there are not adequate records to verify that the “contacts” of the taxpayer with New York State have unequivocally ceased. Multiple residences can create problems. The New York State Department of Taxation may want copies of telephone bills, utility bills, charge card bills, or even a non-resident fishing license. The lesson to be learned in such cases is that the client must keep a daily diary when outside the State of New York. Receipts of plane tickets, gas charges, motel registrations, in addition to changing voting records, motor vehicle registration, licenses, mail forwarding, church and social club affiliations are important in establishing that the client is no longer a New York resident. It is critical that the client be able to prove a change of domicile and that the client is outside New York State for at least 183 full days each year. In an estate setting and without proper records, failure to prove change of domicile can be costly. 44 TRUSTS UNDER WILL 6.1 Credit Shelter Trust. The proper utilization of the federal unified credit during lifetime or at death cannot be over emphasized. To the extent that the taxpayer makes taxable transfers during life, the amount of the federal unified credit is first used to offset any federal gift tax. Whatever remains of the unified credit at death is available against the taxpayer's federal estate tax. If the decedent leaves a surviving spouse, the unlimited marital deduction usually will cause assets passing to such spouse to be exempt from estate tax. The goal is for the decedent's estate to pay no federal estate tax, and, at the same time, use the remaining unified credit of the taxpayer. If the unified credit has not been reduced by lifetime taxable transfers, it is the equivalent in 2001 to $675,000 of property. As previously mentioned, this exemption equivalent in 2002/2003 increase to $1 million, in 2003/2004 it is $1.5 million, etc. Each taxpayer has his or her own unified credit. Thus, by using the unified credit of both husband and wife, it is possible today to transfer $1.35 million of property to the next generation without the imposition of federal estate tax. However, it is also desirable that the surviving spouse have the use and enjoyment of the $675,000/1,000,000 of property without that property being taxed as part of 45 her estate. This is accomplished through the use of a trust which is established under the decedent's Will. The trust suspends the ownership of property transferred to it. The trustee manages the trust principal for the benefit of the spouse or others who are to receive trust income. The trust is usually for the lifetime of the surviving spouse and upon her death the remaining trust assets are paid over to designated beneficiaries, usually the decedent's children. Assuming that the preservation of the unified credit is important to the plan, it is isolated and a trust is created by the Will to contain the amount of property which the remaining unified credit represents. This is called a "credit shelter trust". This trust may provide that all income is payable to the surviving spouse, or the income can be "sprinkled" among and between the spouse, children and more remote issue. With a sprinkle trust, the first priority is the surviving spouse's income. Assuming that her income requirements are satisfied, the trust may then distribute income to other members of the family unit. Those who receive the trust income will be taxed on it. However, this alternative distribution of trust income can have tax advantages. It avoids adding more assets to those already owned by the surviving spouse, which assets are subject to estate tax at her death. Excess trust income can be paid out for the education of grandchildren, or to help a child with the down payment on a house. Moreover, because the trust income does not vest in any particular beneficiary, creditors cannot attach it. 46 This protection from creditors also applies to the trust principal and is one reason for the use of trusts. There is provision for the invasion or encroachment of trust principal under certain circumstances. The power to invade trust principal is at the discretion of the trustee(s) and absent an abuse of discretion by the trustee(s), the trustees’ decision will not be reviewed by the courts. The standard of invasion of trust principal is based upon the health, support, maintenance or education for the beneficiary, or to allow the spouse to continue in the standard of living enjoyed prior to the decedent's death. Invasion of principal is not based upon the "comfort" of the beneficiary nor the beneficiary's "general welfare". These latter two invasion standards are not deemed by IRS as "ascertainable standards" and could cause the beneficiary to have a taxable interest in the trust for estate tax purposes at the beneficiary's death. Some credit shelter trusts call for the remaining trust property at the death of the surviving spouse to be paid to named designated beneficiaries or a closed beneficiary class. Such designated beneficiaries are said to have a vested remainder interest in the trust which may be taxed as part of the remainder beneficiary's estate if the remainder beneficiary dies prior to the trust income beneficiary. This should be avoided. Wills should not have benefits written in stone. It is far preferable to create flexibility in the trust provisions. Therefore, it is common in our trusts to give to the surviving 47 spouse a nontaxable power to re-arrange the trust principal by her will. This is called a "limited power of appointment" and allows the surviving spouse to take into account changing family circumstances after the first spouse's death. It is sometimes referred to as a "second look" provision. The surviving spouse may wish to continue the property in trust or distribute it to lineal descendants in a fashion different from that originally provided for in the trust. The surviving spouse need not exercise the limited power and if not exercised, then the property will pass, as originally provided in the trust. The credit shelter trust may be used to create a generation skipping trust. The decedent will use both the credit shelter amount and a portion of the $1 million GST exemption to have the trust continue through the lifetimes of his spouse and children, creating, at least in part, a safety net for the family for the future. There is a cost in establishing a credit shelter trust such as annual trustee commissions. However, when compared to the fees of a financial advisor, or the annual internal management fees of a mutual fund, a trustee's commission may be lower. Also, consider that over the course of time, the investments of the credit shelter trust principal will grow, so that the amount of property passing to the remainder beneficiaries should be well in excess of the original unified credit shelter trust legacy. 48 6.2 Disclaimer Trust. Both New York and IRS allow a person to refuse to accept an inheritance. No one can force a person to accept property, whether that property is a legacy, income from a trust, the proceeds of life insurance or other property passing to a designated beneficiary or joint owner. The ability to refuse or "disclaim" property can present planning opportunities. One such opportunity is the disclaimer trust and, as might be expected, its use must follow the rules exactly. The prior section explained some of the advantages in the creation of the credit shelter trust. However, some estates, when the Will is drawn, cannot fully use the unified credit, or the client does not want to make a commitment to the establishment of the credit shelter trust. The disclaimer trust allows a "wait and see" approach, or a deferral of the decision until the death of the first spouse. In such an instance, the first spouse's Will provides that the entire estate is bequeathed to the surviving spouse and thus, the entire estate is eligible for the unlimited marital deduction, so that no estate tax will be due. However, the first spouse's Will allows the surviving spouse at the first spouse's death to disclaim so much of the property passing to her as is appropriate to fund, in part or in whole, a credit shelter trust. In other words, only if the surviving spouse elects, after the death of the decedent, will property, by her disclaimer, fall into a residuary credit shelter trust. The 49 surviving spouse is usually the sole income beneficiary of this disclaimer trust. Another form of this strategy is to create a QTIP out of the residue and allow the spouse to disclaim into a pure credit shelter trust. She will not be allowed to have a non-taxable limited power of appointment. The loss of the use of the nontaxable power of appointment is a cost with the disclaimer trust. While the "wait and see" approach may be appropriate in certain circumstances, there is a loss of trust flexibility and as a practical matter, the likelihood of a surviving spouse making the decision to put assets over into a trust of which she does not have direct control is remote. In addition, if an error is made and the surviving spouse accepts any residuary asset or its income, prior to her making an effective disclaimer, the disclaimer strategy will be destroyed. If the error is not initially detected, the result can be that the trust will be included in the surviving spouse's estate because she made a transfer with a retained life interest and made a taxable transfer of a remainder interest. The simple cashing of a check by the surviving spouse may be sufficient to destroy the possibility of the use of the disclaimer trust. If such a trust arrangement is contemplated, care must be exercised in both its planning and at the first spouse's death. 6.3 QTIP Trust. Previous mention has been made of the qualified terminable interest property trust (QTIP) which will qualify for the marital deduction. The trust is 50 required to distribute all of its annual income to the surviving spouse and no person may have an interest in the trust except the surviving spouse during her lifetime. At the surviving spouse's death, the remaining trust principal is distributed as directed by the trust's provisions. The advantage of this trust is that it avoids estate tax upon the first spouse's death due to the unlimited marital deduction and therefore, the wealth of the family is not diminished by estate taxes. However, the trust's value at the surviving spouse's death is fully included in her estate for estate tax purposes, even though the property passes to trust remainder beneficiaries as selected by the first spouse. This trust is especially appropriate for second marriages where the decedent wishes to provide for the surviving spouse, but upon her death, the decedent wants the trust assets to go to his children. Also, the trust is used when, as in other trust situations, the surviving spouse may lack investment expertise, not want to manage assets, or it is the desire of the decedent to insulate trust principal assets from the potential claims of the surviving spouse's creditors, such as long term health care costs. The IRS has never warmed up to the QTIP trust, insisting that its provisions be strictly observed, even when the application of local law was not contemplated by the federal tax code. For example, in the past the federal estate tax return (Form 706) required that the QTIP election be affirmatively made on the return. Although the schedule on the tax return for the marital 51 deduction may have reflected the use of the QTIP, the recapitulation used it, the tax was so calculated, and the Will provided for it, if a particular box was not checked on the estate tax return, the IRS denied the estate the marital deduction. This has now been corrected with legislation that states that if the executor does not want to use the QTIP provisions, then an affirmative election not to use it must be made. In another example, the IRS took the early position that if, upon the death of the surviving spouse, any trust accrued and undistributed income was not paid to the surviving spouse's estate at the death of the surviving spouse, then the marital deduction would be denied because the spouse and her estate would not receive all the trust income. This position has been modified by IRS. Any time that the QTIP trust is used, care must be taken in the application of the tax non-apportionment clause in the will of the surviving spouse. Most wills provide that the payment of estate taxes is to be made from the residuary estate. The reason for this is to avoid the sharing of the estate tax burden (apportioning it) among those who receive assets either outside the will or under the terms of the instrument. For example, when a cash legacy of $1,000 is made under a Will to a child, most testator's intend the child to receive the $1,000 amount, not $1,000 less $150 in taxes attributed to that legacy. Knowing that the QTIP trust is fully includable in the surviving spouse's estate, for estate tax purposes, a direction in the surviving spouse's 52 Will to pay the estate taxes from the residue of her estate may cause the entire estate tax burden to fall upon the estate assets of the surviving spouse even though the property in the QTIP trust passes to the children of the first spouse. Provision should be made when drafting the QTIP trust to specify that the estate taxes arising as a result of the inclusion of the trust in the gross estate of the surviving spouse shall be payable from the QTIP trust itself. 53 6.4 QDOT Trusts. The Internal Revenue Code has been referred to as a document which reflects social policy. If so, its estate tax treatment for the non-citizen surviving spouse beneficiary is myopic. Specifically, the Code denies the unlimited marital deduction for property passing to the surviving spouse if such spouse is not a citizen of the United States. This tax provision, which also sets limits on the gifting of property to a non-citizen spouse, is the only tax law which discriminates against a U.S. citizen who happens to be married to a national of another country. It is alleged that this tax provision was put into law because of a concern that such surviving spouse, if she left the United States, would reduce the nation's wealth. Of course, this "policy" consideration never takes into account the vast national wealth that is lost annually due to the trade deficit. Moreover, in most cases, the surviving spouse's children and grandchildren live in the United States as citizens, and the likelihood of abandoning those contacts is remote. The law also ignores the fact that such surviving spouse has helped her husband's business, has paid local, state and federal taxes and improved the community. It is shameful that the citizen's family is punished by a tax which applies to property passing to a non-citizen spouse. It is in fact discrimination against the U.S. citizen's right to be treated in a fashion similar to other U.S. citizens. 54 While the Treasury policy is to cause a severe tax penalty by denial of the marital deduction for property passing directly to the non-citizen surviving spouse, the tax law allows a special trust to be set up which will qualify for the marital deduction. It is called a Qualified Domestic Trust (QDOT). The trust is in the nature of a QTIP trust. 6.5 Charitable Trusts. Just as the marital deduction, generally, is unlimited, so too, outright gifts or legacies to charity are also unlimited. In addition, there are occasions when it is the desire of the donor or decedent to provide income for the life of a beneficiary and to have a charity benefit after the death of such income beneficiary. Prior to 1969, it was possible to set up a trust where the beneficiary received all of the trust income plus principal could be invaded based upon an ascertainable standard, and the estate would still receive a charitable deduction for the value of the theoretical remainder interest which would eventually pass to charity. Due to the invasion provisions of the trust, it was possible that, in fact, the charity would receive nothing. The 1969 Tax Act introduced limitations on the payment provisions of charitable trusts, sometimes referred to as "split interest" trusts. Specifically, the law stated that such trusts must provide a designated format for the disbursement of income and that the principal could not be invaded at the discretion of the Trustee for 55 the income beneficiary. The decedent could have an annual trust distribution based upon a stated dollar amount calculated as a percentage of the value of principal at the time the trust was funded, so that the same amount would be distributed each year by the trust. Alternatively, the annual distribution could be based upon a percentage of the fair market value of the trust as determined annually. The decedent could pick the percentage pay out, and the charitable deduction allowed to the estate would be the value of the remainder interest eventually passing to charity based upon: (1) the age of the beneficiary or beneficiaries, (2) the percentage applicable for the annual trust distribution and (3) the amount of property placed in the trust. Where there was a recurring payment of the same amount annually, this was called a charitable remainder annuity trust. Where the annual trust distribution could fluctuate based upon the annual market of the trust, this was called a charitable remainder unitrust. This is the law today. Inasmuch as there are competing interests in the use of the charitable trust, serious thought should be given to the matter. Through computer assisted models, the client can have a clearer picture of the tax benefits. The client must weigh the amount of initial funding of the trust, the annual income for the beneficiary, the value of the charitable deduction and the risk of whether to base future annual trust payments on a sum certain or on the annual fair market value of the trust, taking into account the effects of inflation on 56 future purchasing power. The following table is an illustration of the different results when a $200,000 trust is established by a decedent for an income beneficiary age 70. % applied 5 6 7 8 9 Income amount 10,000 12,000 14,000 16,000 18,000 Charitable Deduction 129,478 115,373 101,269 87,164 73,060 If the trust was a unitrust for the beneficiary, and it increased in fair market value to $350,000 in 1998, the income distribution based on a 6% return would be $21,0000 compared to $12,000 as initially funded. Note that if the percentage to be applied is large, then the charitable deduction will be lower and the trustee may be under considerable pressure to invest funds to meet current income needs so that there is a small remainder for charity. Generally, from an investment perspective, the greater the income, the lower the opportunity for the growth of trust principal. Also, since the trust pays no tax on capital gain, more funds are retained by the trust as it increases in value. 57 Obviously, the establishment of a charitable remainder trust will require close evaluation. The other type of split interest trust which is used by an estate or can be established during lifetime (rarely) is called a charitable lead trust. Under the provisions of this trust, the distribution from the trust is given to charity on an annual basis for a term of years. A percentage is applied as with a charitable remainder annuity trust. The estate will receive a charitable deduction based upon the income interest which will pass to charity for the term of years with the remainder interest passing to family members at a future time. At the decedent's death, family members may receive a separate portion of the estate to carry them through the charitable lead term of the trust. The other portion of the estate passes to a charitable lead trust. A charitable lead trust of $200,000 for a term of 12 years at 7% interest will result in a charitable deduction of $104,930 or 52.5% of the amount initially funded. On the other hand, a chartible lead trust for a 20 year term at 8.5% will result in almost a 100% charitable deduction. 58 TRUSTS DURING LIFETIME Revocable “Living” Trusts. Much has been written about the use of revocable, or "living" trusts, but their use is neither new nor revolutionary. The revocable trust, just as with any trust, is designed to meet the specific needs of the client during lifetime and at death. A lifetime living trust is treated as a contact between the Grantor, sometimes referred to as the Settlor, and the Trustee who holds and administers property for the benefit of the Grantor during the Grantor's lifetime, after which the Trustee pays over or continues to hold the property as the trust directs. The Grantor retains the power to alter, amend or revoke the trust during the Grantor's lifetime. The advantages of the revocable trust are that (1) its provisions are private, unless the trust holds real property which is disposed of later, (2) the trust offers continuity of management in the event of disability or death and (3) the trust will save executor commissions. The media attention given to the living trust has primarily related to the use of self-trusteed living trusts and the fear created that people or the "Court" will rip off the decedent and injure his or her family financially. Some 7.1 proponents of such trusts, in fact, use such fear in the "sale" of such trusts and charge unconscionable fees to "help" set up such trusts. 59 Some facts about the revocable living trust are in order. First, the revocable trust does not save any estate taxes. So long as a client has the power to designate who will benefit from trust property at death, or the client continues to retain the use and enjoyment of the trust property, the value of the trust property, generally, will be included in the client's gross estate for estate tax purposes. Any estate tax savings which occur arise from the proper planning under sections of the Internal Revenue Code. Second, the use of the revocable trust does not protect assets from creditors of the Grantor. For example, such trusts are specifically considered a "resource" for purposes of medicaid eligibility. Third, if the trust contains real property and such property is disposed of by the trustee at any time, the trust document will have to be recorded in the County Clerk's office to show the authority of, and title in, the selling trustee. Fourth, the trust may save executor commissions at death, but in many instances, a spouse or other family member will serve as executor and the commission will be waived. Fifth, the client will still need a will which in all likelihood will have to be probated in order to cause any property held outside the trust at death to be poured over into the trust after death. Sixth, while the use of the revocable trust will save initial Court filing fees, this speaks to New York State's desire for revenue. Florida, for example, has a single probate filing fee of under $150 which covers all estate proceedings. Seventh, it is alleged that the use of such a revocable trust will 60 save legal fees. There is nothing in the establishment of a revocable trust which would cause attorney's fees to be reduced for a client's estate. Eighth, it is suggested by some that an advantage of the revocable trust is that distributions of the income or other trust assets can proceed immediately after death. Inasmuch as the trustee is liable for the taxes which may be due and the creditors who must be paid, the trustee would do well to exercise caution. If an estate is properly planned, the immediate cash needs of the family are met. Moreover, contrary to assertions by trust promoters, no Court order is needed in the administration of the estate for distributions of income or assets or the payment of taxes and bills. The revocable trust does have an advantage in the estate of a client who has holdings of real estate in various state jurisdictions. It will avoid ancillary probate proceedings in such jurisdictions. However, the property will have to be appraised (if not sold) and the state death taxes and creditors will have to be paid. Also, the trust document will have to be filed to show ownership in the chain of title to the parcel and the trustee's power to sell or distribute. There are a number of states such as Florida, California and Arizona which permit self-trusteed trusts where the client is the Grantor, the Trustee and the beneficiary. These states have statutes which cover the creation of self-trusteed trusts. New York in July, 1997, passed such a law. (See Revocable Trust booklet). 61 Finally, the Tax Act of August 10, 1993, placed additional limitations on the eligibility for medicaid. Revocable intervivos trusts are specifically referred to as "resources". The only trusts which are specifically exempt from the medicaid laws are trusts created by will. The revocable trust whether self-trusteed or not which continues for the benefit of the surviving spouse may or may not be exempt from the medicaid rules. There is no specific exemption. Revocable trusts have their place principally in the management of assets. Consideration may be given to a "stand-by" revocable trust. In such an instance, the Trustee is merely a custodian of assets unless the Grantor becomes disabled. At the time of disability, the “standby” Trustee assumes full responsibility for trust management and bill paying. Another variation is to authorize the establishment of a revocable trust by the person whom the client has appointed as agent under a power of attorney. At the time of the client's disability, the client's assets are placed into trust by the client's attorney-in-fact. In conclusion, be sure you are not "sold" on any estate planning technique before you understand its benefits, limitations and purposes. 62 7.2 QTIP Trust You will recall that the unlimited marital deduction permits the free transfer of assets between spouses, at least between citizen spouses. From the preceding section, you were introduced to the testamentary QTIP trust created under the client's will for the benefit of the surviving spouse who, during her lifetime, is the only person who can have an interest in the trust and she has to receive all of the trust's annual income. Upon the surviving spouse's death, the property will pass to trust remainder beneficiaries. Under the tax law prior to 1981, such an arrangement would have been a terminable interest and the marital deduction denied. The QTIP trust can be created during lifetime by one spouse for the benefit of the other spouse. The reason to create such a trust is to cause property to be transferred for the benefit of the surviving spouse and have that property taxed in her estate, since she may be in a lower estate tax bracket. In the event of her premature death, her unified credit will be used. This may be particularly appropriate if the non-propertied spouse is in poor health. In addition, since all of the trust income is for the benefit of the spouse, the spouse who created the trust could indirectly have access to the income, if the income is deposited in a joint bank account. This should not be done by pre-arrangement, so that trust may be attacked by IRS as a sham. 63 The IRS regulations involving the creation of a lifetime QTIP trust are uncharacteristically generous. It is possible for spouse A to create a QTIP trust for the benefit of spouse B, providing that all of the income be paid over to her annually, provide for invasion of principal (not in satisfaction of the support obligation), give spouse B a limited taxable power of appointment, which if not exercised by spouse B's will, causes trust income at spouse's B's death to be paid over to spouse A, who created the trust, and continue on the trust at A's death as a generation skipping safety-net trust. The GST exemption is made when the trust is set up by A and all of the trust appreciation over future years will be protected from the 55% GST tax. Additionally, this trust can be set up by A with provision that after B's death, the income is to be sprinkled to A or his descendants, allowing a full step up in basis of the trust property at B's death. The regulations even allow A, who created the trust, to have a limited nontaxable power of appointment created in the trust after spouse B's death under the terms of the trust. Ordinarily, the creation of such a power by the grantor (spouse A) would cause the trust to be included as part of spouse A's estate. But the regulations view the trust, properly created, as the property of spouse B and it is "as if" she created the continuing provisions for the payment of income and principal after her death. The regulations even allow A to create the QTIP trust for B and upon B's death, if the trust income is payable to A for his lifetime and no one else 64 has an interest in the trust during A's lifetime, B's executor may elect to treat the trust as a QTIP trust in B's estate, or at least so much as is above B's unified credit. A double QTIP. Once at creation of the trust and again at B's death. Some questions remain. For example, if A transfers property to B and both A and B set up QTIP trusts for the benefit of each other, what is the tax effect? Ordinarily, the reciprocal trust doctrine would apply and the IRS would view each trust as a sham. Given the strong language of the regulations would the reciprocal trust doctrine apply? Another question deals with the rights of creditors of A. Can A insulate trust property from his creditors with the use of a QTIP trust where the income is paid to his spouse? If the marriage is strong, is this not a way to protect assets if A is in a high-risk profession, such as a neurosurgeon? Caution is again urged in dealing with the source of the payment of the estate taxes from the QTIP trust upon the second spouse's death and the application of a tax non-apportionment clause. Also, the gift tax QTIP election must be affirmatively made on a timely filed gift tax return by the creator of the QTIP trust, due April 15 in the year following its creation. Another point to be underscored is that estate tax planning opportunities still exist even when time is critical. 65 7.3 Irrevocable Insurance Trusts. In the examination of the client's assets, the estate planner looks to see if there are assets which the client need not own and whether such assets can be transferred to others to help reduce the size of the client's estate. Usually, these assets are represented by pieces of papers which provide little, if any, current financial benefit to the client. Contracts of life insurance or shares of stock in a closely held business are common candidates. Must the client own 100% of the common stock of the company if it is his intention to pass that stock to his son who is contributing to the present growth of the business? Must the client be the owner of substantial sums of life insurance on his own life if he intends to benefit his wife or children with the proceeds? Is it cost effective to allow the proceeds of life insurance to generate the very estate tax which the policies are designed to pay for? The answer is that there are better ways of using life insurance contracts for the protection of loved ones or to provide reduced values in a business estate tax setting. It must be noted that whenever the insured/owner makes a gratuitous transfer of a policy of insurance on his or her life to a third party, there is a three year gift in contemplation of death rule which will cause the proceeds of the policy to be included in the insured/owner's estate if the death is within three years of the transfer. What are some of the choices available for life insurance ownership? 66 One approach is to have the wife become the owner of the policy on the husband's life and to name herself as the beneficiary. If the policy is gifted to her by the husband, there is no gift tax consequence and even if the husband dies within three years of the transfer, the proceeds received by her are eligible for the unlimited marital deduction. Another approach is for the wife to be the owner/applicant at the inception of the policy so that her husband has no ownership interests in the policy and he is merely the insured. The proceeds do not form part of his estate. Moreover, if the wife predeceases the husband, the policy is given to their children or becomes part of a trust which continues to pay the policy premiums with the eventual proceeds passing tax free to the children. Another approach involves the use of a irrevocable life insurance trust (ILIT). In the traditional insurance trust, the Grantor is the owner of the policies which are transferred to a trust in which the Grantor has no interest. The Grantor has made a gift of the policies and retains no ownership interests in the policies. The trust is irrevocable. Upon the Grantor's death, hopefully more than three years after the transfer, the proceeds are paid over to the trust and the proceeds either continue in trust or are paid outright to the trust beneficiaries. The problem presented is that the creation of a lifetime irrevocable trust will cause the ownership of property to be suspended in the name of the trust. IRS views this kind of transfer as the creation of a "future 67 interest" which is not eligible for the annual gift tax exclusion. Thus, any property transferred to such a trust is a taxable transfer and subject to the application of a gift tax return. This result is not all that bad, since due to the nature of the insurance contract and the leveraging of premiums to proceeds, a substantial amount of property is being removed from the estate. But it would be better if the gift tax annual exclusion could be used to reduce or avoid a taxable transfer. If insurance policies are to be transferred to children, care should be exercised, since in order to get the annual gift tax exclusion, the children must each have unfettered ownship rights in the policy, independent of each other. One type of irrevocable insurance trust which uses the annual gift tax exclusion is called a "Crummey" trust. This is, in fact, the prior irrevocable insurance trust, but now the trust beneficiaries are each given a limited time frame or "window" in which to withdraw a portion of the contribution made to the trust by the Grantor. The concept, which has been begrudgingly approved by the IRS, causes the annual contribution of the Grantor to the trust to be eligible to be withdrawn from the trust by the beneficiaries, thereby changing a future interest into a present possessory right in the beneficiary. Accordingly, the Grantor has not made a taxable transfer since the interest transferred is not a future interest but instead a present possessory interest eligible for the annual gift tax exclusion. The window of withdrawal is usually 30 days. The 68 contribution by the Grantor can be the policies, the premiums, or both. The beneficiaries, who must know of the trust, need not, and often do not, withdraw the contributions made to the trust by the Grantor. Each year as the policy premium comes due, an additional cash contribution is made to the trust and the beneficiaries are notified. The beneficiaries do not sign waivers. Detailed records are kept to prove that the notices are mailed each year. Some planners will limit the beneficiaries' withdrawal right to the greater of the amount of 5% of the fair market value of the trust or $5,000. With this limitation, the beneficiary is not viewed as having a general power of appointment over his or her interest in the trust, so that a portion of the trust is not taxed as part of the beneficiary's estate if the beneficiary dies. In such instances, this limitation will use only $5,000 of the allowable $10,000 annual gift tax exclusion attributable to the beneficiary. Other planners will authorize the withdrawal right up to the full $10,000 level. This position is based upon the conclusion that it is really not important whether a portion of the trust is part of the child's gross estate since the child's estate, if he predeceases the Grantor, has its own federal unified credit. Such predeceased child's unified credit will be more than sufficient to cover a portion of the modest cash value of the policy which is held in the trust. A final approach is to use the basic irrevocable insurance trust, add the Crummey powers, make a contribution of cash to the trust and have the trustee 69 become the owner/applicant for the policy from the beginning. The Grantor never has any ownership rights in the policy. Thus, at the trust's inception, the proceeds will be free from estate tax and income tax. This type of trust was created by a lawyer named Headrick whose estate successfully fought the IRS and avoided inclusion of the policy proceeds in the estate. There are other factors which enter into the establishment of an insurance trust. Will the type of policy be term, whole life with a vanishing premium, split dollar with a corporation or a last to die policy? Does the client wish to establish the trust to replace the wealth which will be used to pay estate taxes at death? Given the probability that the wife will survive the husband and that the unlimited marital deduction will avoid taxes in the husband's estate, should the wife establish the trust and does she have the resources to pay the premiums? What cash will be needed 5 or 10 years from now? How much protection is needed, and for what period of time? Can the client afford to pay the premiums? 7.4 Charitable Trusts. The establishment of lifetime charitable split interest trusts can be advantageous to the Grantor depending upon a number of factors. The client must weigh the same factors as those found in an estate tax setting, but with a view to the income tax deduction which will be available as a result of a 70 lifetime split interest charitable trust. In most instances, the Grantor will retain for his/her own lifetime the annuity or unitrust annual income distribution. At the death of the income recipient, the remaining property held in the trust will be transferred to charity. The ideal scenario arises when the client has very low tax cost assets which are producing a small amount of dividend income. The charitable trust is a tax exempt entity. Thus, the Grantor transfers to the trust low tax cost assets which are thereafter sold by the trust and the proceeds reinvested. There is no capital gain tax payable by the trust so that the full amount of the proceeds are available for reinvestment at a higher return. The income from the trust, as stated in the trust instrument, is significantly higher than that previously earned on the assets originally contributed to the trust. Cash flow to the Grantor is increased and at the same time, the Grantor will receive today a charitable deduction for the remainder interest which will pass to charity in the future. The full use of the charitable deduction in a single tax year will depend upon the Grantor's adjusted gross income for the tax year and there are percentage limitations on the deduction, but the Grantor has a five year carry forward for any unused deduction. In addition to outright gifts and charitable trusts, charitable deductions are available for pooled income funds (usually established by a college or university) and for a charitable remainder interest with a personal residence 71 where the owner continues to use the residence during lifetime. At death, the residence belongs to charity. Also, the client may establish a charitable lead trust which is usually funded with cash since the trust is not a tax exempt entity and low basis assets would not be used to fund it. Charity gets the income for a term of years and the remainder will be paid to the Grantor’s children. The Grantor will receive an income tax deduction for the income interest paid over to the charity, but subsequent earnings will be taxed to the Grantor, even though the distribution is to charity. Unless you win the lottery or have a large cash infusion in one year, this is not a realistic lifetime planning option.. 7.5 Grantor Retain Income Trusts. Under the Tax Law, if a client transfers assets and retains the income from those assets until death, the assets will be included in the client's estate because the client has retained the use and enjoyment of the property. But if the retention of the right to enjoy the income from the assets is only for a term of years, after which the property will pass to the client's children, would the property be included in the client's estate? Has the client made a gift of the remainder interest which will pass to the children? Is the income interest retained by the client capable of being valued? What if the client dies before 72 the term of the retained income interest is complete? Grantor Retained Income Trust (GRIT)? What exactly is a A GRIT is a trust similar to the charitable split interest trust where the income portion of a asset is distinguished from the remainder portion of the asset and when both portions are valued, they equal 100% of the value of the asset to be transferred to the trust. The value of the income interest will depend upon the percentage of income retained by the Grantor in the trust and the number of years for which the trust is established. Whatever is left over is the remainder interest. The income interest is not viewed as a gift from the Grantor since the Grantor retains the income right. The remainder interest is viewed as a gift of a future interest and therefore, it represents a taxable transfer, and it is subject to gift tax. Remember that at the end of the term of the trust, the trust assets are paid over to the remainder person(s). If the client creates a GRIT and retains an income interest worth 10% per year, and the trust lasts for 10 years, then 61.5% of the trust assets as originally funded will be viewed as the retained income interest and 38.5% will be viewed as the remainder interest. If the trust was funded with $200,000, then the client would be making a gift of the remainder of $77,000 at the inception of the trust. Further, if the trust increased in value over the ten year term to $500,000, then all of the appreciation of the asset which would otherwise have been part of the client's estate will have escaped estate tax in the client's estate. 73 If nature follows its proper course, the client will have removed $500,000 of assets from his estate at a gift tax value of $77,000. This is called leveraging. The "risk" is that the Grantor may not survive the ten year term of the trust. If the Grantor dies during the term of the trust, then the tax rule first mentioned is applicable and the property, plus appreciation, is fully included in the client's estate. Yet, for a married taxpayer, the "risk" may not be as great as might be expected because the unlimited marital deduction is available to the client's estate. Thus, if the client dies during the term of the trust, the property comes back to the client's estate and is part of the property passing to the surviving spouse. Moreover, for a married or single taxpayer, it is possible to establish an irrevocable insurance trust which will provide cash for the payment of estate taxes if the trust creator (Grantor) does not survive the term of the trust Of course, whenever there is a perceived abuse with an estate planning technique, the federal government (IRS) moves to stop the threat to revenue loss. Perception in politics is reality. In the case of GRITs, the purported abuse was the use of the government's own tables which allowed for a 10% income factor to be used to determine the value of the retained income interest. The abuse was that the trust would be funded with assets which produced 2 or 3% income, but the income interest was based upon a 10% interest factor which caused the remainder interest to be very small, and thus, the amount of 74 the taxable transfer was small for gift tax purposes. In addition, the government did not like leveraging of the GRIT and passed section 2702 of the Code which, except for certain statutory GRITs, treats the transfer of the above example of leveraging as a completed transfer for gift tax purposes. Thus, the splitting of the income and remainder interests will be denied unless the GRIT, with certain exceptions, is structured in a new statutory form. Leveraging is still possible in a rising stock market, but not as great as before. Today, the choice for a GRIT is a common law GRIT (as to tangible personalty and certain real estate) or a unitrust grit, which is called a GRUT, or an annuity grit, which is called a GRAT. Even though the interest rate tables have now changed to a monthly floating rate (the 7520 rate), the use of the leveraging effect of the Grantor retained income trust still represents an important estate planning tool, because if the client does nothing, the estate taxes to be paid are probably going to increase. What does the client have to lose? The GRAT is like a GRIT in terms of structure except it requires a specific percentage pay out each year. The concept calls for a large payout percentage and ideally one tries to zero out the remainder interest in order to pass out to the remainder beneficiaries the asset appreciation which can occur. For example, suppose A creates a GRAT for a term of 3 years and the GRAT requires a 33 and 1/3 % . Since the trust is a GRAT, the amount of the 75 payments is fixed, like an annuity, over the term of the trust based upon the amount used to originally fund the trust. If A funds the GRAT trust with $300,000, then the pay out each year is $100,000 back to A.. This payment can be with a portion of the trust corpus. A will be taxed on the trust income (accounting income whether it is distributed to him or not.) Thus, over the course of the payment term, the trust corpus /income will be returned to A and at the end of the trust whatever remains is paid over to the remainder beneficiaries. If the trust appreciates, the remainder beneficiaries will receive the increase in the value of the trust assets. There is still leveraging which combined in a rising market can cause appreciation to pass to the remainder beneficiary, as with the original GRIT. 7.6 Personal Residence Trust. There remains a type of GRIT which pertains to the client's personal residence, and to one additional residence, if so desired. The qualified personal residence retained income trust is a GRIT into which the Grantor's home is transferred for a term of years. The trust is sometimes referred to as a QPRT. This can be a particular appropriate device in dealing with a lake residence or a home which may appreciate substantially in value (which is the 76 assumption in most GRITS), and the asset, in all probability, will continue in the family for successive generations. The numbers must be looked at carefully, since if the asset does not increase in value, it may be better to simply gift portions of the property to children over the course of future years by the use of other entities. This will depend upon the overall tax planning for the client since the client may wish to use the QPRT ( ataxable transfer of the remainder interest) and continue to use the annual gift tax exclusion for other planning opportunities. If, however, it is likely that the lake property will increase substantially in value, then the property would be transferred to the trust with the Grantor retaining the use and enjoyment of the property during the trust term. There is provision in the Tax law that the sale of the property back to the Grantor will not cause capital gain to be recognized since the Grantor for income tax purposes is viewed as the owner of the trust as long as it is in existence. There is not a taxable event when a person sells his own property to himself. But, at the same time as the Grantor is "buying" the property back so that he can continue to use it in the future, the "proceeds", (i.e., cash) paid come into the trust tax free and pass to the remainder interest in lieu of the real property. The Grantor would still retain his old basis in the real estate, but upon death, his estate would receive a new or stepped up basis. In spite of these Grantor 77 trust rules, the IRS has taken the position by proclamation that to allow the Grantor to repurchase the residence from the trust will disqualify the trust. Of course, the real estate need not be purchased by the Grantor. It can continue in further trust for the children’s lifetimes. If this is the case, then there are Generation Skipping Tax issues with which to deal. Or it can be rented to the Grantor at a fair market rental. 78 PENSION AND PROFIT SHARING BENEFITS Over the past twenty years, the estate tax treatment of pension and profit sharing benefits has run the gamut from total inclusion to total exclusion, to partial exclusion, to full inclusion, to an additional excise tax on deemed excess benefit accumulations. The pension/profit sharing benefit, together with IRA plans, may represent an estate's most significant asset category. 8.1 Spousal Rights. In the "old" days, it was not uncommon for a husband to retire and he would select whether he wished to take a pension based solely upon his life expectancy or he could select a joint and survivor annuity which provided a lower payment for both his and his wife's lifetimes. Since he had no knowledge of mortality tables, nor the insurance industry, he thought he would live forever. He would beat the odds. Well, the odds are about 50% that a person will live to their projected life expectancy. A client can make the decision by the flip of a coin, if so inclined. For those who wanted less risk, the client could purchase life insurance with part of the difference in dollars between the higher single life payout which he selected and the lower amount 79 received under a survivor pension annuity. The wife was often not aware that a single life payout election had been made and, upon the death of the husband, she was placed in real economic peril with no continuing source of income other than social security. Today, with the establishment of laws by the federal government covering the funding and payment of qualified retirement plan benefits, it is presumed that the worker will elect a joint and survivor annuity. To opt out of that election, a signed consent is required by the other spouse. 8.2 Spouse's Election to Roll-Over Benefit. As has already been mentioned, the husband and wife have a special status for estate tax purposes and are viewed as a single economic unit or partnership. Accordingly, for an IRA or a qualified plan of which the spouse is the designated beneficiary, the surviving spouse is permitted to roll-over the proceeds of the IRA account or qualified plan benefit into her own IRA at the death of the first spouse without the recognition of income. The surviving spouse if under age 70 1/2 years may continue to enjoy the benefits of income tax deferral on the IRA earnings. Indeed, the transfer should be made from the qualified plan or husband's IRA directly to the custodian of the surviving spouse's IRA. Failure to cause a direct transfer from a qualified plan to the IRA custodian will result in a 20% withholding tax, and this 20% will be 80 recognized for income tax purposes as a taxable distribution. Therefore, before the qualified plan benefit is paid over to the surviving spouse, care should be exercised to make sure the benefit is not mistakenly taxed. This can easily happen at the time of death when a surviving spouse is under stress. 8.3 Options for Payment of Pension/Profit Sharing and IRA Benefits. Qualified plans which incorporate pension or profit sharing, or both, can be paid out in a lump sum to the designated beneficiary assuming that the spouse's consent is given, or there is no surviving spouse. Presently, the law has repealed the five year averaging provision under which the pension benefit was divided by 5, the tax is calculated on this one fifth amount and then the tax is multiplied by 5. The result was that a modest benefit could be taxed at the lowest rates possible under the income tax law. As the amount of the benefit increases, so does the income tax. Inasmuch as the benefit is fully taxable for estate tax purposes in the estate of a single taxpayer, and is subject to income tax as well, it is considered IRD. Thus, the estate tax which arises as a result of including the pension benefit in the taxpayer's estate may be used as a deduction against income for income tax purposes. This is known as a 691(c) deduction. It is not a tax credit, but merely a deduction. 81 For IRA's, there are a number of options in addition to the spousal rollover. The IRA benefit can be paid out over a 5 year period. Alternatively, if the IRA owner was at death in payout status and designated a younger child as the beneficiary, the IRA can continue payments after the death of the owner to the child based upon the child's life expectancy, with payments coming out of the IRA each year to the child.. A separate book is available at the website for your review of the issues to be evaluated in pension/profit sharing and IRA benefits at death. It is particularly important when considering early retirement and post death distributions to beneficiaries. 82 BUSINESS SUCCESSION PLANNING The planning for the orderly transfer of a business interest is perhaps the most complex matter which faces the planner and the client due to the competing interests which emerge, as well as, some unfavorable tax provisions applicable to the transfer of family business in estates. Often, the business represents the life's work of a client and the client is reluctant to commit to a plan which will impact the client's total control of the business. The business, in a competitive market, faces stresses of its own. Further, the older generation which has guided the business through wars and recessions may not have sufficient confidence in the younger generation's ability to lead the business into the uncertain future. Occasionally, there are simply too many family members for the business to financially support and difficult decisions must be made. Yet, the son or daughter who has come into the business pays a financial price in that the salary paid to the child is usually below market. Moreover, the child is viewed by other family members as responsible for the parents, thereby allowing the other siblings to make their own way in the business world. And, those same siblings, as the parents grow older, come to expect an equal share of the business to which they have given nothing of themselves. Those same siblings have an unrealistic view of the value of the business which is a view usually encouraged by their spouses 83 (those damn in-laws). The business owner must focus on what is in the best interest of the business and those in the family who care about its success. 9.1 Buy-Sell Agreements. For persons who start and continue a business entity, whether a corporation or a partnership, the buy-sell agreement is a requirement for any plan. If the parties are not related, there can be a great difference between the agreed value, or formula valuation, for the business and what the business is actually worth. This low value will be binding on the IRS for estate tax purposes. If, on the other hand, the parties to the enterprise are, in fact, related, there is greater concern by IRS, and if the parties are father/son or father/grandson, then the IRS is not going to accept large disparities in value. In the latter case, discounts that are claimed in an estate tax setting will be hard fought for. The preferred valuation approach for a business by IRS is based upon its earning capacity. The past five years of financial statements are examined, and the greatest weight is given to the most recent tax years. For this reason, and for corporate income tax reasons, business owners in their later years will want the business to have relatively flat earnings if the plan involves passing the business on to a child. If the business shows a nominal profit, then its valuation will be depressed for gift and estate tax purposes. If the business has assets which have been substantially depreciated, the IRS will seek to value those assets at their fair market value and try to 84 approach the valuation of the business based upon its underlying asset value. From the taxpayer's view point, the estate may try to argue that the book value, less adjustment for accounts receivable over 90 days and good will, is a proper value. Taxpayers have tried to argue that if the business was liquidated, not only would its value be low, but the corporation would be liable for capital gains tax on the sale of its assets, and the tax on the capital gain should further reduce the value of the business. The Courts have only recently agreed with the position that capital gain tax does allow a separate discount in value of the business due to the repeal of the general utilities doctrine. When dealing with a Buy-Sell Agreement, the estate's concern is not that the agreement will bind the estate for transfer purposes, but that the agreement will not bind the IRS estate tax purposes. Thus, the estate may end up paying estate tax on a value for the business which value is in excess of the agreement. There are two types of Buy-Sell Agreements. The first type is an agreement between the shareholders to purchase the shares of stock of any deceased shareholder. The corporation is not primarily obligated in the agreement. Funding of the purchase price is usually accomplished by life insurance with shareholder A owning a policy on the life of shareholder B and shareholder B owning a policy on the life of shareholder A. Upon B's death, A receives the insurance proceeds and pays for the stock in whole or in part. If the latter, there is usually a promissory note for the balance of the purchase 85 price with a pledge of stock as collateral and personal guarantees. The policy on A's life owned by B's estate may be transferred to A, the insured, for its cash value. The second type of Buy-Sell agreement involves the corporation, which, upon the death of the shareholder, will redeem, or purchase, the shares of the deceased shareholder. This will enhance the value of the shares of the remaining shareholders and can lead to changes in control of the corporation and in its operation in the future. Again, insurance is often used to fund this Buy-Sell arrangement. However, if the corporation receives insurance proceeds, those proceeds may be subject, at least in part, to alternative minimum taxation. Also, the IRS will attempt to include the value of the proceeds in the value of the corporation for estate tax purposes. The preferred method of Buy-Sell agreements is the one between shareholders, sometimes referred to as a "cross purchase" plan. Most Buy-Sell agreements will have a formula provision to determine the value of the business and the value of the shares. In arriving at the formula, consideration should be given to reasonable discounts for both lack of marketability and, as appropriate, minority ownership. It has been observed that shares on the New York Stock Exchange do not represent the full value of the shares, but rather, the value of such publicly traded shares is about 70% of 86 full value. Such a 30% discount is applicable for shares which have a ready market. The problem with most Buy-Sell agreements is that they are not reviewed and updated to reflect the fair value of the business and what the business (or other shareholder) can afford to pay when one of its principal owners dies. The value should be fair to the business and fair to the estate of the owner. If, considering the circumstances, the valuation is reasonable, IRS is more likely to accept the agreement between related parties. The fact that shareholders are related parties results in transfers becoming suspect by IRS, which considers agreements between related parties as methods of transferring property for less than fair market value and therefore, there is the possibility of revenue loss. There are a number of Code sections which impact family transfers. One Code section is 318 and relates to the family attribution rules. This section of the Code creates a fiction comparable to a large fishing net. Its intention is to catch in the net all of the ancestors and lineal descendants who own stock or may have an interest in stock in the family corporation. Its penalty is to treat a distribution by the company on the redemption of stock by the company as a taxable dividend. For example, if a father's stock in the company is redeemed by the company upon his retirement, the payments to the father by the company under Section 318 would be characterized as a dividend because the father's ownership of the 87 shares and the son's ownership of shares are treated as a single ownership interest. Since the fictional combined ownership was only partially redeemed (the father's shares), there is dividend treatment of distributions to him. However, there is an exception. If the father executes a written waiver of the attribution rules and agrees not to come into the business for a period of 10 years, then the redemption of his shares by the corporation will not result in dividend treatment. A redemption of shares at the death of the father can lead to serious tax problems because there is not a person to execute a waiver. To avoid this, the shares could be given to the spouse and she could execute the waiver. Note that section 318 is applicable to corporate redemptions. It does not apply to the cross purchase of shares by another family shareholder or the purchase of shares from the decedent's estate by the trustee of an irrevocable insurance trust. 9.2 Recap of Shares (fractionaling/ voting/ nonvoting) It used to be possible for a corporation to recapitalize its shares, thereby creating common stock and preferred stock. The preferred stock represented about 95% or more of the company's value and the common stock represented a minimal value. The preferred stock had a non-cumulative dividend feature, was usually non-voting and was redeemable at par. The preferred stock issuance was subject to Section 306 of the Code, which meant that if the 88 preferred stock was transferred or sold, income would be recognized by the transferor. The preferred stock was usually held until death in order to receive a step-up in basis. Since the preferred stock could only be redeemed at par value, the value of this stock was fixed for estate tax purposes. This was the stock which the older generation continued to hold. The common stock, which would absorb all future appreciation was transferred to the younger generation. This was referred to as an "estate freeze". IRS shouted "foul". The Courts upheld the taxpayer. Thus, to combat this perceived abuse by family business shareholders, Congress enacted section 2036(c) and then section 2701. Under section 2701, if preferred stock was retained and the common stock was transferred to the younger generation, IRS will consider the gift of the common stock as a complete transfer of the business entity (another fiction) and, therefore, subject to a transfer tax substantially in excess of that encountered under the prior law. There are still planning opportunities for small business corporations, especially for subchapter S ("S corporations") or even C Corporations and LLC’s. If the business is to remain in the family, it is important to fractionalize the ownership of the business entity. For example, the business owner may recapitalize the S corporation's stock into voting and non-voting shares, giving away the non-voting shares to the younger generation and retaining the voting shares; or perhaps the establishment of a GRAT with the S shares would be in 89 order. The Grantor would continue to receive the income, and the appreciation in the shares could eventually pass to the next generation. installment sale should be used. Perhaps an 9.3 Limited Family Partnerships ( more fractionalizing) In order to have a valid partnership for tax purposes, the partnership must either be formed for a non-tax reason or the partnership must actually engage in a business or investment activity. Thus, there are non-tax considerations or business tax purposes for which a limited partnership is formed. 1. Non-tax reasons for limited partnership include the following: a. The ability of the senior partners to control the distributable cash flow of the partnership; perhaps due to lack of confidence in the younger partners and the desire to invest income retained by the partnership, but taxed to the partners. b. The desire to consolidate multiple investments for ease of management and reduce costs. c. Create a vehicle for gifting divisible property into convenient units for gifting. 90 d. Create an incentive to continue to hold family investments through Buy-Sell Agreements. e. Some protection of partnership assets from creditors of individual partner and control of partnership assets. f. Unlike Trusts, Partnership Agreements are easily amended and partnerships are subject to business judgment not prudent investor rule. Investments may involve greater risk. g. Partnerships can resolve disputes by stipulation to arbitration or other agreed methods to resolve disputes. h. Ease of dealing with investments in multiple jurisdictions. Real property is viewed as an intangible for estate tax purposes and subject to estate tax in partner's domicile state, avoiding of estate tax in the jurisdiction of the location of the property. i. Limitation on partnership liabilities, present and future. 2. Tax reasons for the formation of a family limited partnership include the following: a. Fractionalize interests in partnership to obtain discounts due to minority discounts and lack of marketability and lack of ability to liquidate the partnership. b. Ease of transfer of in kind assets from partnership vs. corporation. 91 c. d. Income conduit to partner's individual tax return. Ease of creation by contribution of assets without a taxable event (usually) and ease of termination. Historically, the use of a partnership was abused by simply allocating income purposefully away from the high-income bracket taxpayer. The IRS put a stop to this with Section 704, allocating income by capital of the partners. Partnership interests may be used by the older generation or the client may wish to use a LLC, Limited Liability Company, which permits management to be under a shareholder managing agreement. 92 SELECTING THE EXECUTOR, TRUSTEE OR GUARDIAN One of the most important decisions to be made in the estate planning process is the nomination of a person or banking institution to administer the client's estate. Who does the client trust to protect and preserve his or her property? The administration of an estate may involve business judgment, investment expertise, sensitivity to the emotional and financial needs of the family and confidentiality. First, the client should consider the appointment of family members, such as the surviving spouse or one of the children. Usually, if the nomination of a child is considered, it is best not to nominate all of the children. The nomination of all children will lead to a committee approach to estate administration and will frustrate the decision making process. Sometimes, the conflicts, which occurred between children in the past, will reemerge upon the death of both parents. Moreover, adult children are often given advice by their respective spouses, who do not appreciate the desire for family continuity. When a son-in-law says at a meeting that he is there to "protect my wife's interests", it is clear that he has come with his own agenda, which may have little regard for the other family members opinions or feelings. 93 Occasionally, the client asks his lawyer to be Executor/or Co-Trustee. Where there has been a long relationship with the client and only at the client's request, would such an appointment be considered. The legal representative of an estate is responsible to the estate beneficiaries for the administration of the decedent's estate. The job involves the collection of assets, the payment of creditors, the filing of necessary tax returns, payment of taxes when due and the distribution of the estate as directed in the decedent's Will. If the party nominated has special skills or expertise, the law requires that those skills be used in the administration of the estate at no additional charge. If the legal representative has special skills, such legal representative is held to a higher standard of performance than an ordinary citizen. In all cases, however, the legal representative must take affirmative action to exercise reasonable and prudent judgment. Failure to act promptly and prudently will result in a surcharge by the Court against the legal representative if the estate sustains losses. Banks with trust powers are often appointed legal representatives. The reasons for this are numerous, including experience, investment expertise, privacy and the value of having a disinterested party making decisions which might otherwise cause conflict within a family. The job of the executor is a temporary one. For an estate under $600,000, the administration may be complete within one to one and one-half 94 years. Indeed, in a small estate, the file can often be completed by the close of the statutory seven months creditor's period. In a larger estate, it is our practice, after consideration of proper post mortem planning, to recommend that approximately 80% of the net estate be distributed by the end of the first nine months. The estate must be kept open until the executor receives clearance from IRS and New York State for the estate tax returns filed. Technically, IRS has 3 years from the date the return is filed to audit the return. Usually, if there was no tax payable, a closing letter will be issued by IRS within 6 months after filing the return. If an estate tax was paid, a closing letter may be received within 12 months. If an estate tax was paid and there were gift or valuation issues, the estate may be audited. The audit notice will come within 12 to 14 months after the return is filed. The audit process by IRS may take a week or several months depending upon the information sought and whether there can be agreement on the issues raised. The closing of the estate will depend upon when the federal estate tax issues are resolved, and at that point, the New York State tax return is amended, and a New York State tax closing letter is received. During this period of time, the executor's final account is prepared for settlement of the estate. Usually, the estate beneficiaries, after reviewing the account, will sign receipts and releases, which are filed with the Court. This will avoid an additional Court filing fee. 95 If the estate is large, the executor may desire the finality of a decree of judicial settlement. Some clients inquire about the amount of commissions to which an executor is entitled. Such statutory commissions are as follows: AMOUNT $100,000 next $200,000 next $700,000 next $4,000,000 RATE 5% 4% 3% 2½% COMMISSION $ 5,000 8,000 21,000 Commissions are deductible (dollar for dollar) against estate income if so elected as part of the post mortem tax plan. Excess deductions (administration expenses in excess of estate income) in the estate's final income tax year can be passed on to the estate beneficiaries. The appointment by the Court of the trustee of any trust created by the Will is sometimes accomplished when the Will is probated, or occasionally, the appointment is made when the estate is prepared to fund the trust created by the decedent's Will. The trustee's job is a long term effort, often for the lifetime of the income beneficiary. A bank (or trust company) with trust powers is particularly appropriate for this appointment because (1) the bank will always be there, (2) the bank has no bias between any beneficiary, (3) the bank offers investment expertise and (4) by experience and training, it is 96 prepared to complete and file all trust income tax returns, as well as accountings. Most often, a family member is appointed as co-trustee with the bank. This gives the family member a veto power and causes the bank to be more attentive to changes which are on going within the family. For example, if a family member is a co-trustee, the bank must consult with the family member trustee regarding investment programs for the trust, and discretionary income distribution and principal invasions. At the same time, the use of the bank can insulate the family member from unreasonable requests for money from a beneficiary. "Blame it on the bank." The appointment of a guardian, who is responsible for the day to day care of the decedent's infant children, is very important. Sometimes, the decision of who the guardian should be is made by the process of elimination. If possible, a family member should be nominated. While friends may be "close" to a client, it will be the family members who will care the most about the client's infant child. Ultimately, the appointment of the Guardian will be determined by the Surrogate Court. The Court will place great weight upon the client's selection of the guardian as set forth in the client's Will. If the guardian lives in a different county or state, the Court within such county or state will be responsible for the guardian appointment. This is based upon the jurisdiction where the child resides. 97 POWERS OF ATTORNEY, HEALTH CARE PROXIES, LIVING WILLS and MEDICAID 11.1 Power of Attorney. A power of attorney authorizes another person (an agent) to act in the client's behalf and the agent can legally bind the client ( the principal). The document is very powerful and is effective when it is signed. A durable power of attorney is made durable by the addition of language that the power survives the disability or incompetency of the principal. There was some question under prior case law whether the power was valid if the principal became incompetent and lacked the capacity to revoke the power. Of course, the very reason for granting the power in the first place was to deal with the possible future disability of the principal. The power should be drawn so that the power holder can deal with IRS, plus the agent should be authorized to continue to make gifts for the principal as part of the client's gifting program. The law does not deal well with a client's disability. The law provides a guardianship procedure which is cumbersome, expensive and causes delay, all of which most clients wish to avoid. The use of the power of attorney can avoid the use of such a guardian. 98 Some powers of attorney are called "springing" powers which become effective upon the happening of a particular event. While it may appear simple to designate the event which causes the power to become effective, this condition puts a third party who is expected to rely upon the validity of the power on notice and such a third party may require proof that the event has, in fact, occurred. The usual practice is for the client to execute the power, and it is retained with the original will of the client in the law firm's permanent client file in the vault. The power is filed with the County Clerk's office when requested by the client or when a family member has advised that there is a problem.. Copies are given to the agent in order to deal with the property of the client. The power of attorney cannot be used for health care decisions. 11.2 Health Care Proxies. Until 1990, the New York Legislature was reluctant to provide for a health care agency relationship. In spite of the New Jersey case of Karen Quinlan, it was not until the U.S. Supreme Court's decision in the Nancy Cruzan case that the Legislature acted. The essence of the Cruzan decision was that Nancy Cruzan was compelled by Missouri law to remain on life support systems absent "clear and convincing" evidence of her wishes to the contrary. This evidentiary standard is the highest level of proof in a civil 99 lawsuit. It is also the standard in New York. Justice O'Connor indicated that a person would be able to delegate the authority for the making of medical decisions. The New York State Attorney General had already come to that conclusion. Based upon the Supreme Court's decision, the Legislature passed the Health Care Proxy law, which allows a client to name a person to make health decisions for the principal, but only if the principal is unable to participate in such health care decisions. A health care proxy is freely revocable. The law also provides for an alternate agent. The law does not permit multiple agents acting at the same time. 11.3 Living Wills. Various organizations over the years have encouraged the use of a living will as an expression of a person's desire that heroic measures not be taken to keep the person alive by mechanical means if there is no hope of recovery from a terminal illness or injury. It was uncertain what the legal effect was of such a declaration. The New York State Court of Appeals has now said that such a document would be "ideal" in satisfying the clear and convincing standard of evidence needed to terminate mechanical life support systems where there was no hope of recovery. Upon signing a living will and/or a health care proxy, the client is given a wallet card indicating the execution of such document(s). 100 11.4 Medicaid. For the family of moderate or limited assets, there is often a concern about the devastating financial effects of a catastrophic long-term illness. Because the nature of nursing home care is generally considered "custodial", there is no coverage for such "custodial" care by Medicare. The cost of nursing home care may run from $5,000.00 to $6,000.00 per month. The average nursing home stay is about four (4) years. The initial question is whether the client is likely to be a candidate for such long term care. This may involve the client's judgment about (1) the probability of needing such care based upon the prior family medical history, (2) the reportedly 20% of the population which may require such care and (3) the present health of the client. Over the past decades, both the federal and state governmental budgets have taken up the payment of nursing home care for citizens who were truly poor. With advances in medical care, more and more tax dollars have been expended at the federal, state and county levels. The expenditure of tax resources has been heightened due to the transfer of assets by persons who 101 anticipate the need for such care in the future. The federal and state governments accordingly have made it increasingly difficult to become eligible for Medicaid. Prior to 1988, a person's personal residence was exempt as a resource and was often transferred to other family members. Part of the 1993 Clinton Tax Act continued governmental efforts to restrict Medicaid eligibility. For example, under prior law there was a look back period of 30 months of the application for Medicaid. Now, this look back period has been extended to 36 months and the look back period for a trust creation is 60 months. In addition, the law now provides that if a trust is established with the Grantor retaining an interest, the entire trust can be viewed as a resource of the Grantor depending on the terms of the trust. Revocable trusts are clearly resources. Trusts created under a Will are not resources. One option available to the client is the acquisition of long term health care assistance. Such insurance will involve a discussion of the client's income and investments. There have been occasions when children of a client have paid for the insurance since the children had good salaries and wanted to make sure that their parents would not have to worry about this future expense. The law regarding Medicaid is continually changing and involves careful planning. 102 ATTORNEY FEES By the cannons of ethics, attorneys fees are to be reasonable. The client should have an appreciation of the matter to be resolved, its complexity, the results obtained, the time expended and the fees generally charged in the community for similar services. 12.1 Planning. It is no surprise that a person usually gets what he or she pays for. We have no interest in applying a cookie cutter approach to estate/trust planning. The estate planning process is important to the client and to us, since there is no better way to understand what the client wants or needs. We do not come to the planning process with a predisposed plan into which the client must fit. We cannot give the client our best advice without the planning process. Our fees are generally based upon the time required to meet the client's objectives. An average fee range for some plans: Basic plan with simple Will, Power of Attorney (POA), Health Care Proxy (HCP) and Living Will (LW) Basic plan, Will with credit shelter trust, residue outright, POA, HCP and LW Revocable Living Trust with dispositive provisions, pour-over Will, POA, HCP and LW 103 $ 350 - 500 $ 700 - 975 $1,625 - 2000 Irrevocable Insurance Trust Charitable Remainder Trust $1,625 - 2,000 $1,600 - 2,450 For matters which require complex planning, the charge will be discussed with the client at the first planning meeting. 12.2 Estates. After the death of the client, the estate is usually administered from our office, because the executor must render an accounting in the future, and unless a bank is the executor, we need to have the records in house. We use computer assisted accountings, thereby allowing the executor to have a statement of all estate transactions upon request. In most instances, all estate transactions will originate from our office. In addition to the legal work, we explain to the executor the estate tax issues and options and recommend a course of action. The executor's job is to use his or her best judgment. Collection of assets, review of debts with the executor, payment of bills, preparation of estate tax returns, transfer of assets and conclusion of the estate proceedings all will initiate from our office. This service permits the spouse, or a child, who serves as executor to waive their statutory commissions. Our average legal fee on a gross estate of $500,000 would be in a range of between $15,000 and $19,000. Note should be made that attorneys fees, as well as other administration expenses, are deductible against estate income, so that, as part of the post mortem tax plan, income can be accumulated by the estate on a tax free basis. 104 For the larger estate which is required to file a federal estate tax return, representation involves a longer period of time and presents additional tax issues, there is, a larger fee. For an $800,00 estate, the legal fee will be in the range of $22,000 to $24,000 compared with an attorney fee based upon an executor's commission of $28,000. We believe that our approach to legal fees is reasonably reflective of the value of both our time and advice. Please feel free to ask about our legal fees. 105 CONCLUSION 13.0 The contents of the manual have discussed a number of the concepts to help the client understand the upcoming estate planning discussions and documents needed to complete the plan. The emphasis has been and will be on creating choices and flexibility together with a reduction in tax liabilities. Asset protection is considered. The plan developed today represents your best judgment and our best advice. The plan should be examined annually to make sure it is right for you. We want your future to be well ordered. Thank you for the time which you have taken to read this manual. We believe it is informative. Your comments about its value to you and its clarity of explanation are welcomed. We look forward to serving as your legal counsel to help you meet your estate planning goals. 106 EXHIBIT A. TABLE OF DESCENT AND DISTRIBUTION EPTL § 4-1.1 (EFFECTIVE 9/1/92) TABLE OF DESCENT AND DISTRIBUTION PATERNAL G’PARENTS OR THEIR “ISSUE” MATERNAL G’PARENTS OR THEIR “ISSUE” PATERNAL FIRST COUSINS ONCE REM’D MATERNAL FIRST COUSINS ONCE REM’D ISSUE ISSUE OF PARENTS SPOUSE PARENTS $50,000 + ½ RESIDUE ½ RESIDUE “BY REP’N” ENTIR NO E ESTATE ENTIRE EST. “BY REP’N” NO ½ EACH OR ALL TO SURVIVOR NO NO NO NO NO ENTIRE EST “BY REP’N” NO NO NO NO ½ TO P-GPS OR “ISSUE” “BY REP’N” ½ TO M-GPS OR “ISSUE” “BY REP’N” NO NO NO NO NO ALL TO GPS OR “ISSUE” “BY REP’N” NO NO NO NO ALL TO GPS OR “ISSUE” NO 107 “BY REP’N” NO NO NO NO NO NO ½ TO PFCOR PER CAPITA ½ MFCOR PER CAPITA NO NO NO NO NO NO ENT EST TO FCOR PER CAPITA NO NO NO NO NO NO NO ENT EST TO FCOR PER CAPITA Persons more remote from the decedent than the First Cousins Once Removed (who are defined as “great grandchildren of the decedent’s grandparents”) are not distributees. Consequently, if no one in any of the classes of distributees listed above survived the decedent, the estate which passes by intestacy will escheat to the State of New York. 108 EXHIBIT B. Federal and New York Estate Tax (Year 2000) Taxable Estate Fed. Tax NY Tax Net Tax Rate (Gross) (State Credit) (Federal) Net Fed. Tax 675,000.00 750,000.00 900,000.00 1,200,000.00 1,500,000.00 2,000,000.00 2,500,000.00 3,000,000.00 4,000,000.00 5,000,000.00 0 27,750.00 86,250.00 207,250.00 335,250.00 560,250.00 805,250.00 1,070,250.00 1,620,250.00 2,170,250.00 0 20,400.00 (4.8%) 27,600.00 (6.5%) 45,200.00 (6.4%) 64,400.00 (6.4%) 99,600.00 (7.2%) 138,800.00 (8.0%) 182,000.00 (8.8%) 280,400.00 (10.4%) 391,600.00 (11.2%) 0 7,350.00 58,650.00 162,050.00 270,850.00 460,650.00 666,450.00 888,250.00 1,339,850.00 1,778,650.00 0 34.2 33.4 34.6 36.6 37.8 41.0 44.2 44.6 43.8 Note: New York provided for a previously taxed property credit only if it exceeded the federal state death tax credit on the second death. As of 2/1/2000, that has been repealed. For example, if at A’s death, A’s estate pays a New York estate tax, based upon a taxable estate of $900,000, amounting to $27,600, and his property passes to B. If B dies the next day with a taxable estate of $1,200,000, B’s estate will pay to New York State a new estate tax of $45,200 and there will be no credit to B’s estate for the payment in A’s estate of $27,600. 109 110